1. No category

THE TEXAS OIL AND GAS BUSINESS TODAY:
WHAT'S HAPPENING AND HOW TO INVEST
SELECTED LEGAL ISSUES:
CHOICE OF ENTITY
DIRECTOR AND OFFICER FIDUCIARY DUTIES
BYRON F. EGAN
Jackson Walker L.L.P.
901 Main Street, Suite 6000
Dallas, TX 75202-3797
began@jw.com
LONDON
March 6, 2008
Copyright© 2008 by Byron F. Egan. All rights reserved.
CHOICE OF ENTITY
By
BYRON F. EGAN
Jackson Walker L.L.P.
901 Main Street, Suite 6000
Dallas, Texas 75202-3797
began@jw.com
LONDON • MARCH 6, 2008
Copyright© 2008 by Byron F. Egan. All rights reserved.
5030707v.1
TABLE OF CONTENTS
I.
GENERAL...........................................................................................................................1
A.
Introduction....................................................................................................................1
B.
Statutory Updating .........................................................................................................3
C.
Texas Business Organizations Code..............................................................................4
1.
Background ..............................................................................................................4
2.
Source Law Codified ...............................................................................................4
3.
Hub and Spoke Organization of Code .....................................................................5
4.
Effective Date ..........................................................................................................6
5.
Changes Made By the TBOC ..................................................................................6
(a)
Vocabulary ..........................................................................................................6
(b)
Certificate of Formation ......................................................................................7
(c)
Filing procedures.................................................................................................7
(d)
Entity Names .......................................................................................................8
(e)
Governance..........................................................................................................8
(f)
Construction ........................................................................................................9
(g)
Transition Rules ..................................................................................................9
D.
Federal “Check-the-Box” Tax Regulations ...................................................................9
1.
Classification............................................................................................................9
2.
Check-the-Box Regulations ...................................................................................10
(a)
Eligible Entities .................................................................................................10
(b)
The Default Rules..............................................................................................10
(c)
The Election Rules ............................................................................................11
(d)
Existing Entities ................................................................................................11
3.
Former Classification Regulations.........................................................................11
(a)
Continuity of Life..............................................................................................12
(b)
Centralization of Management ..........................................................................13
(c)
Limited Liability ...............................................................................................13
(d)
Free Transferability of Interest..........................................................................13
E.
Texas Entity Taxation ..................................................................................................14
1.
Corporations and LLCs, but not Partnerships, Subject to Pre-2007 Franchise Tax14
2.
Franchise Tax Change Proposals ...........................................................................14
3.
Margin Tax.............................................................................................................16
(a)
Who is Subject to Margin Tax ..........................................................................16
(b)
Passive Entities..................................................................................................19
(c)
LLPs ..................................................................................................................20
(d)
Prior Chapter 171 Exemptions ..........................................................................20
(e)
Small Business Phase-In ...................................................................................20
(f)
Basic Calculation...............................................................................................21
(g)
Gross Revenue Less (x) Compensation or (y) Cost of Goods Sold ..................21
(h)
Gross Revenue...................................................................................................21
(i)
The Compensation Deduction...........................................................................23
(j)
The Cost of “Goods” Sold Deduction ...............................................................23
(k)
Transition and Filing .........................................................................................24
(l)
Unitary Reporting..............................................................................................24
i
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(m)
(n)
(o)
(p)
(q)
Combined Reporting .........................................................................................25
Apportionment ..................................................................................................26
Credits / NOL’s .................................................................................................27
Administration and Enforcement ......................................................................27
Effect of Margin Tax on Choice of Entity Decisions........................................27
4.
Constitutionality of Margin Tax ............................................................................28
5.
Classification of Margin Tax Under GAAP ..........................................................31
6.
Internal Partnerships Will Not Work Under Margin Tax ......................................31
7.
Conversions............................................................................................................32
F.
Business Combinations and Conversions ....................................................................33
1.
Business Combinations Generally .........................................................................33
(a)
Merger ...............................................................................................................33
(b)
Share Exchange .................................................................................................33
(c)
Asset Sale ..........................................................................................................34
2.
Conversions............................................................................................................37
(a)
General ..............................................................................................................37
(b)
Texas Statutes....................................................................................................37
(c)
Federal Income Tax Consequences...................................................................38
(1)
Conversions of Entities Classified as Partnerships....................................38
(2)
Conversions of Entities Classified as Corporations...................................39
(d)
Effect on State Licenses ....................................................................................40
G.
Use of Equity Interests to Compensate Service Providers...........................................40
H.
Choice of Entity ...........................................................................................................40
II.
CORPORATIONS.............................................................................................................40
A.
General.........................................................................................................................40
B.
Taxation .......................................................................................................................41
1.
Taxation of C-Corporations ...................................................................................41
2.
Taxation of S-Corporations....................................................................................42
(a)
Effect of S-Corporation Status ..........................................................................42
(b)
Eligibility for S-Corporation Status ..................................................................43
(c)
Termination of S-Corporation Status ................................................................43
(d)
Liquidation or Transfer of Interest ....................................................................44
3.
Contributions of Appreciated Property..................................................................44
4.
Texas Entity Taxes.................................................................................................44
5.
Self-Employment Tax............................................................................................44
C.
Owner Liability Issues .................................................................................................44
D.
Management.................................................................................................................46
E.
Fiduciary Duties...........................................................................................................48
1.
General...................................................................................................................48
2.
Business Judgment Rule ........................................................................................49
3.
Overcoming Business Judgment Rule ...................................................................50
4.
Limitation of Director Liability .............................................................................50
F.
Ability to Raise Capital................................................................................................50
G.
Transferability of Ownership Interests ........................................................................51
1.
Restrictions on Transfer of Shares .........................................................................51
2.
Securities Law Restrictions....................................................................................51
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5030707v.1
H.
Continuity of Life ........................................................................................................52
I.
Formation.....................................................................................................................52
J.
Operations in Other Jurisdictions.................................................................................53
K.
Business Combinations; Conversions..........................................................................53
L.
Anti-Takeover ..............................................................................................................54
III.
GENERAL PARTNERSHIP .............................................................................................54
A.
General.........................................................................................................................54
1.
Definition of “Person” ...........................................................................................55
2.
Factors Indicating Partnership ...............................................................................55
3.
Factors Not Indicative of Partnership ....................................................................56
4.
Joint Venture..........................................................................................................57
B.
Taxation .......................................................................................................................57
1.
General Rule ..........................................................................................................57
2.
Joint Venture/Tax Implications..............................................................................57
3.
Contributions of Appreciated Property..................................................................58
4.
Texas Entity Taxes.................................................................................................58
5.
Self-Employment Tax............................................................................................58
C.
Owner Liability Issues .................................................................................................58
D.
Management.................................................................................................................60
E.
Fiduciary Duties...........................................................................................................60
1.
General...................................................................................................................60
2.
Loyalty ...................................................................................................................60
3.
Care ........................................................................................................................61
4.
Candor....................................................................................................................61
5.
Liability..................................................................................................................61
6.
Effect of Partnership Agreement ...........................................................................62
F.
Ability To Raise Capital ..............................................................................................62
G.
Transferability of Ownership Interests ........................................................................62
1.
Generally................................................................................................................62
2.
Partnership Interests as Securities..........................................................................63
H.
Continuity of Life ........................................................................................................64
I.
Formation.....................................................................................................................64
J.
Operations in Other Jurisdictions.................................................................................65
K.
Business Combinations................................................................................................66
IV.
LIMITED PARTNERSHIP ...............................................................................................66
A.
General.........................................................................................................................66
B.
Taxation .......................................................................................................................66
1.
Federal Income Taxation .......................................................................................66
2.
Contributions of Appreciated Property..................................................................67
3.
Texas Entity Taxes.................................................................................................67
4.
Self-Employment Tax............................................................................................67
C.
Owner Liability Issues .................................................................................................68
D.
Management.................................................................................................................69
E.
Fiduciary Duties...........................................................................................................69
F.
Indemnification ............................................................................................................76
G.
Flexibility In Raising Capital.......................................................................................76
iii
5030707v.1
H.
I.
J.
K.
L.
Transferability of Ownership Interests ........................................................................77
Continuity of Life ........................................................................................................78
Formation.....................................................................................................................79
Operations in Other Jurisdictions.................................................................................80
Business Combinations................................................................................................81
V.
LIMITED LIABILITY COMPANY. ................................................................................81
A.
General.........................................................................................................................81
B.
Taxation .......................................................................................................................83
1.
Check the Box Regulations....................................................................................83
2.
Other Tax Issues Relating to LLCs........................................................................83
(a)
Texas Entity Taxes ............................................................................................83
(b)
Flexible Statute..................................................................................................84
(c)
One Member LLC .............................................................................................84
(d)
Contributions of Appreciated Property .............................................................85
(e)
Self-Employment Tax .......................................................................................85
C.
Members; Managers.....................................................................................................87
D.
Purposes and Powers....................................................................................................88
E.
Formation.....................................................................................................................88
F.
Company Agreement ...................................................................................................89
G.
Management.................................................................................................................91
H.
Fiduciary Duties...........................................................................................................92
I.
Indemnification ............................................................................................................96
J.
Capital Contributions ...................................................................................................97
K.
Allocation of Profits and Losses; Distributions ...........................................................97
L.
Owner Limited Liability Issues ...................................................................................98
M.
Nature and Classes of Membership Interests.............................................................100
N.
Assignment of Membership Interests ........................................................................104
O.
Dissolution .................................................................................................................105
P.
Merger; Conversion ...................................................................................................107
Q.
TLLCA Relationship to TBCA and TMCLA............................................................108
R.
Foreign LLCs .............................................................................................................110
S.
Professional LLCs......................................................................................................111
T.
Diversity Jurisdiction .................................................................................................112
VI.
LIMITED LIABILITY PARTNERSHIP ........................................................................112
A.
General.......................................................................................................................112
B.
Background ................................................................................................................113
C.
Liability Shielded.......................................................................................................115
1.
LLP Shield ...........................................................................................................115
2.
Limits to LLP Shield............................................................................................116
3.
Burden of Proof....................................................................................................117
4.
LLP Status Does Not Affect Liability of Partnership..........................................118
5.
Shielded vs. Unshielded Obligations ...................................................................118
6.
Contractual Obligations Incurred Prior to September 1, 1997 ............................118
7.
Other State LLP Statutes......................................................................................119
D.
Requirements for LLP Status.....................................................................................119
1.
Name ....................................................................................................................119
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2.
3.
Filing with the Secretary of State of Texas..........................................................120
Insurance or Financial Responsibility..................................................................121
E.
Taxation .....................................................................................................................123
1.
Federal Tax Classification ...................................................................................123
2.
Texas Entity Taxes...............................................................................................123
3.
Self-Employment Tax..........................................................................................123
F.
Other Issues................................................................................................................123
1.
Advertisement of LLP Status...............................................................................123
2.
Assumed Name Certificate ..................................................................................124
3.
Time of Compliance ............................................................................................124
4.
Effect on Pre-LLP Liabilities...............................................................................125
5.
Limited Partnership as LLP .................................................................................125
6.
Indemnification and Contribution........................................................................126
7.
Inconsistent Partnership Agreement Provisions ..................................................126
8.
Fiduciary Duties...................................................................................................127
9.
Foreign LLP Qualification...................................................................................127
10.
Bankruptcy...........................................................................................................130
11.
Federal Diversity Jurisdiction ..............................................................................130
VII. EXTRATERRITORIAL RECOGNITION OF LLC AND LLP LIMITED LIABILITY130
A.
General.......................................................................................................................130
B.
Texas Statutes ............................................................................................................131
C.
Texas Cases................................................................................................................131
D.
Decisions in Other States ...........................................................................................134
E.
Qualification as Foreign Entity and Other Ways to Reduce Extraterritorial Risk.....137
VIII. DECISION MATRIX ......................................................................................................138
IX.
CONCLUSION................................................................................................................141
APPENDIX A – Entity Comparison Chart
APPENDIX B – Basic Texas Business Entities and Federal/Franchise Taxation Alternatives
Chart
v
5030707v.1
CHOICE OF ENTITY
BY
BYRON F. EGAN*
I.
GENERAL
A.
Introduction
In selecting a form of business entity in which to engage in business in the United States,
the organizer or initial owners should consider the following five business entity forms:
Corporation
General Partnership
Limited Partnership
Limited Liability Partnership (“LLP”)
Limited Liability Company (“LLC”)
The form of business entity most advantageous in a particular situation depends on the
objectives of the business for which the entity is being organized. In most situations, the focus
will be on how the entity and its owners will be taxed and the extent to which the entity will
shield the owners of the business from liabilities arising out of its activities.
Until the 1990s, the spectrum of business entity forms available in Texas was not so
broad. In 1991, the Texas Legislature passed legislation allowing for the creation of the LLP and
the LLC, which changed the business organization landscape in Texas and nationwide. In 1991,
Texas adopted the world’s first LLP statute permitting a general partnership to significantly limit
the individual liability of its partners for certain acts of other partners by the partnership making
a specified filing with the Secretary of State of Texas (the “Secretary of State”) and complying
with certain other statutory requirements.1 The Texas LLP statute was later amended to extend
*
1
Copyright © 2008 by Byron F. Egan. All rights reserved.
Byron F. Egan is a partner of Jackson Walker L.L.P. in Dallas, Texas. Mr. Egan is Vice Chair of the ABA
Business Law Section’s Negotiated Acquisitions Committee and former Chair of its Asset Acquisition
Agreement Task Force, and a member of the American Law Institute. Mr. Egan is a former Chairman of
the Texas Business Law Foundation and is also former Chairman of the Business Law Section of the State
Bar of Texas and of that Section’s Corporation Law Committee.
The author wishes to acknowledge the contributions of the following in preparing this paper: William H.
Hornberger, Michael L. Laussade, Steven D. Moore, Monica L. Pace, and John R. Williford of Jackson
Walker L.L.P.; Carmen Flores and Lorna Wassdorf of the Office of the Secretary of State of Texas; and
Elizabeth S. Miller of Baylor University School of Law.
Act of May 9, 1961, 57th Leg., R.S., ch. 158, 1961 Tex. Gen. Laws 289; Act of May 17, 1979, 66th Leg.,
R.S., ch. 723, § 5, 1979 Tex. Gen. Laws 1782; Act of May 9, 1985, 69th Leg., R.S., ch. 159, § 76, 1985 Tex.
Gen. Laws 692; Act of May 9, 1991, 72d Leg., R.S., ch. 901, §§ 83–85, 1991 Tex. Gen. Laws 3234–35; Act
of May 31, 1993, 73d Leg., R.S., ch. 917, § 2, 1993 Tex. Gen. Laws 3912–13 (expired Jan. 1, 1999); see
Susan S. Fortney, Professional Responsibility and Liability Issues Related to Limited Liability Law
Partnerships, 39 S. TEX. L. REV. 399, 402 (1998).
1
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its LLP shield to contracts made after September 1, 1997. Also in 1991, Texas became the
fourth state to adopt a statute providing for the creation of an LLC, which limits the personal
liability of LLC interest owners for LLC obligations at least as much as the liability of corporate
shareholders is limited for corporate obligations. Today, all fifty states and the District of
Columbia have adopted LLP and LLC statutes.2
In 2003, the Texas Legislature enacted the Texas Business Organizations Code (the
“TBOC”) to codify the Texas statutes relating to business entities referenced above, together
with the Texas statutes governing the formation and operation of other for-profit and non-profit
private sector entities. The TBOC became effective for entities formed under Texas law after
January 1, 2006. Entities in existence on January 1, 2006 may continue to be governed by the
Texas source statutes in effect prior to January 1, 2006 or elect to be governed by the TBOC.
Federal and state taxation of an entity and its owners for entity income is a major factor
in the selection of the form of entity for a particular situation. Under the Internal Revenue Code
of 1986, as amended (the “IRC”), and the “Check-the-Box” regulations promulgated by the
Internal Revenue Service (“IRS”), an unincorporated business entity may be classified as an
“association” taxable as a corporation subject to income taxes at the corporate level ranging from
15% to 35% of taxable net income, absent a valid S-corporation status election, which is in
addition to any taxation which may be imposed on the owner as a result of distributions from the
business entity.3 Alternatively, the entity may be classified as a partnership, a non-taxable
“flow-through” entity in which taxation is imposed only at the ownership level. Generally, a
corporation is taxed only as a corporation, but an LLC or partnership may elect whether to be
taxed as a partnership. A single-owner LLC may elect to be disregarded as a separate entity for
federal income tax purposes.
Texas does not have a state personal income tax. Until January 1, 2007, corporations and
LLCs were subject to the Texas franchise tax, which was equal to the greater of (i) 0.25% of its
“taxable capital,” generally owners’ equity, and (ii) 4.5% of its “net taxable earned surplus.”
Although labeled a “franchise tax,” the tax on “net taxable earned surplus” was really a 4.5%
income tax levied at the entity level and computed by determining the entity’s reportable federal
taxable income and adding to that amount the compensation of officers and directors. Limited
and general partnerships, including the LLP, were not subject to this franchise tax.4
In a Special Session, which convened on April 17, 2006 and adjourned sine die on May
15, 2006, the Texas Legislature passed House Bill 3 (“H.B. 3”), which replaced the current
Texas franchise tax on corporations and LLCs with a new and novel business entity tax called
the “Margin Tax,” which is imposed on all business entities other than general partnerships
wholly owned by individuals and certain “passive entities.”5 Essentially, the calculation of the
new Margin Tax is based on a taxable entity’s, or unitary group’s, gross receipts after deductions
for either (x) compensation or (y) cost of goods sold, provided that the “tax base” for the Margin
2
3
4
5
J. William Callison, Changed Circumstances: Eliminating the Williamson Presumption that General
Partnership Interests Are Not Securities, 58 BUS. LAW. 1373, 1382 (2003).
See infra notes 73–86 and accompanying text.
See infra notes 99–102 and accompanying text.
See infra notes 105–184 and accompanying text.
2
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Tax may not exceed 70% of the entity’s total revenues. This “tax base” is apportioned to Texas,
multiplying the tax base by a fraction: of which the numerator is Texas gross receipts and the
denominator is aggregate gross receipts. The tax rate applied to the Texas portion of the tax base
is 1% for all taxpayers, except a narrowly defined group of retail and wholesale businesses who
will pay a ½ of 1% rate. For calendar year taxpayers, the Margin Tax applies to entity income
commencing January 1, 2007, and is payable annually commencing May 15, 2008.
The enactment of the Margin Tax changes the calculus for entity selections, but not
necessarily the result. The LLC becomes more attractive as it can elect to be taxed as a
corporation or partnership for federal income tax purposes, but the uncertainties as to an LLC’s
treatment for self-employment purposes continue to restrict its desirability in some situations.6
B.
Statutory Updating
Texas’ entity statutes are continually being updated and improved through the efforts of
the Texas Business Law Foundation and the Business Law Section of the State Bar of Texas.7
This updating process commenced in 1950 with the organization of the State Bar’s Corporation
Law Committee, which was succeeded in 1953 by what is now the Business Law Section and
was later enhanced by the organization of the Texas Business Law Foundation.8 Continuing this
tradition, the 75th Session of the Texas Legislature (the “1997 Legislative Session”), which
adjourned sine die on June 2, 1997, brought Senate Bill 555 (“S.B. 555”), which became
effective September 1, 1997, making numerous changes in Texas’ business entity statutes, some
of which are quite innovative.9 The changes effected in 1999 and 2001 were relatively limited;
however, in the 78th Session of the Texas Legislature (the “2003 Legislative Session”), which
convened January 14, 2003 and adjourned sine die on June 2, 2003, the TBOC was passed,10 and
significant changes were made to Texas’ other entity statutes.11 In the 79th Session of the Texas
6
7
8
9
10
11
See infra notes 489–501 and accompanying text.
See Alan R. Bromberg, Texas Business Organization and Commercial Law—Two Centuries of
Development, 55 SMU L. REV. 83, 113–14 (2002); Alan R. Bromberg, Byron F. Egan, Dan L. Nicewander,
and Robert S. Trotti, The Role of the Business Law Section and the Texas Business Law Foundation in the
Development of Texas Business Law, 31 BULL. BUS. L. SEC. ST. B. TEX. 1 (1994); see generally Alan R.
Bromberg, Byron F. Egan, Dan L. Nicewander, and Robert S. Trotti, The Role of the Business Law Section
and the Texas Business Law Foundation in the Development of Texas Business Law, 41 TEX. J. BUS. L. 41
(2005) (displaying the continually changing statutes).
See Bromberg, supra note 7, at 113–14; Bromberg et al., Role of Business-Original, supra note 7, at 1;
Bromberg et al., Role of Business-Updated, supra note 7, at 44.
Tex. S.B. 555, 75th Leg., R.S. (1997); Curtis W. Huff, The New Business Organization Laws: Changes Made
in the 75th Legislature to Address Modern Business Practices, 34 TEX. J. BUS. L. 1 (1997).
Tex. H.B. 1156, 78th Leg., R.S. (2003) by Rep. Helen Giddings available at
http://www.capitol.state.tx.us/home.aspx (select the “78(R) - 2003” Legislature, select Bill Number, then
fill in “HB 1156” in the space below). The Revisor’s Report for the TBOC is available on the Texas
Legislative Council website at http://www.tlc.state.tx.us/legal/bocode/bo_revisors_report.html. The interim
report from the House Sub-Committee studying the TBOC, which contains a side-by-side comparison of
current and proposed law, is available at http://www.house.state.tx.us.
See Tex. H.B. 1165, 78th Leg., R.S. (2003) by Rep. Burt R. Solomons available at
http://www.capitol.state.tx.us/home.aspx (select the “78(R) - 2003” Legislature, select Bill Number, then
fill in “HB 1165” in the space below); see also Tex. H.B. 1637, 78th Leg., R.S. (2003) by Rep. Rene
3
5030707v.1
Legislature (the “2005 Legislative Session”), which convened January 11, 2005 and adjourned
sine die on May 30, 2005, changes were again made to the Texas entity statutes,12 including the
TBOC.13 In the 80th Session of the Texas Legislature (the “2007 Legislative Session”), which
convened January 9, 2007 and adjourned sine die on May 28, 2007, further changes were made
to the TBOC and other Texas statutes affecting business entities.14
C.
Texas Business Organizations Code
1.
Background
In the 2003 Legislative Session, the TBOC, which was previously introduced and not
passed in the 199915 and 2001 Legislative Sessions, was again introduced and this time it
passed.16 The TBOC in its current form17 also includes amendments made during the 2005
Legislative Session and the 2007 Legislative Session.18 The TBOC is still a work in progress,
and additional amendments will be made in the future as gaps and ambiguities are discovered
and as business organization practices and needs evolve. The TBOC provides considerable
flexibility to organizations in establishing their capital structures, effecting business combination
transactions and governing their internal affairs. It is a model for future statutes nationwide and
solidifies Texas’ position as a leader in corporate law.
2.
Source Law Codified
The TBOC is principally a codification of
profit and for-profit private-sector entities, rather
law.19 These statutes consist of the following:
“TBCA”),20 the Texas Non-Profit Corporation Act
12
13
14
15
16
17
18
19
20
the existing Texas statutes governing nonthan substantive modifications to existing
the Texas Business Corporation Act (the
(the “TNPCA”),21 the Texas Miscellaneous
Oliveira available at http://www.capitol.state.tx.us/home.aspx (select the “78(R) - 2003” Legislature, select
Bill Number, then fill in “HB 1637” in the space below).
Tex. H.B. 1507, 79th Leg., R.S. (2005) by Rep. Burt Solomons, available at
http://www.capitol.state.tx.us/home.aspx (select the “79(R) - 2005” Legislature, select Bill Number, then
fill in “H.B. 1507” in the space below); Tex. H.B. 1154, 79th Leg., R.S. (2005) by Rep. Gary Elkins,
available at http://www.capitol.state.tx.us/home.aspx (select the “79(R) - 2005” Legislature, select Bill
Number, then fill in “HB 1154” in the space below); Tex. H.B. 1319, 79th Leg., R.S. (2005) by Rep. Helen
Giddings, available at http://www.capitol.state.tx.us/home.aspx (select the “79(R) - 2005” Legislature,
select Bill Number, then fill in “HB 1319” in the space below) (“H.B. 1319”).
Tex. H.B. 1319.
See Tex. H.B. 1737, 80th Leg., R.S. (2007) by Rep. Helen Giddings available at
http://www.capitol.state.tx.us/home.aspx (select the “80(R) - 2007” Legislature, select Bill Number, then
fill in “HB 1737” in the space below) (“H.B. 1737”), which became effective September 1, 2007.
Thomas F. Blackwell, The Revolution is Here: The Promise of a Unified Business Entity Code, 24 J. CORP.
L. 333, 359 (1999).
Tex. H.B. 1156.
TEX. BUS. ORGS. CODE. ANN. (Vernon 2008), available at http://tlo2.tlc.state.tx.us/statutes/bo.toc.htm.
Tex. H.B. 1319 (2005) and H.B. 1737 (2007).
Ad Hoc Codification Committee, Report of the Codification Committee of the Section of Business Law of
the State Bar of Texas on the Proposed Business Organizations Code, Apr. 16, 2002, at 55, available at
http://www.texasbusinesslaw.org/608127_6_date_12262000.pdf [hereinafter Codification Comm. Report].
TEX. BUS. CORP. ACT ANN. arts. 1.01 et. seq. (Vernon Supp. 2008) (hereinafter TBCA).
4
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Corporation Laws Act (the “TMCLA”),22 the Texas Limited Liability Company Act (the “LLC
Act”),23 the Texas Revised Partnership Act (the “TRPA”),24 the Texas Revised Limited
Partnership Act (the “TRLPA”),25 the Texas Real Estate Investment Trust Act (the “TREITA”),26
the Texas Uniform Unincorporated Nonprofit Associations Act (the “TUUNA”),27 the Texas
Professional Corporation Act (the “TPCA”),28 the Texas Professional Associations Act (the
“TPAA”),29 the Texas Cooperative Associations Act (the “TCAA”),30 and other existing
provisions of Texas statutes governing private entities. Banks, trust companies, savings
associations, insurance companies, railroad companies, cemetery organizations, and certain
abstract or title companies organized under other special Texas statutes are not “domestic
entities”31 under the TBOC; therefore, they are governed by the TBOC only the extent that the
special Texas statute or its source laws incorporate the TBOC by reference or the TBOC is not
inconsistent with the special statute.32 Generally entities organized under Texas special statutes
prior to January 1, 2006 would be subject to the transition rules applicable to other Texas entities
and would continue to generally reference the source law rather than the TBOC until January 1,
2010.33
3.
Hub and Spoke Organization of Code
The TBOC adopts a “hub and spoke” organizational approach under which provisions
common to all entities are included in a central “hub” of the TBOC found in Title 1. These
common provisions include, for example, the primary sections governing purposes and powers
of entities, filings, meetings and voting, liability, indemnification of directors and partners, and
mergers among entities. Outside Title 1, separate “spokes” contain provisions governing
different types of entities which are not common or similar among the different entities. To
determine applicable law for a given business entity, one should look first to the general
provisions in Title 1, and then to the entity-specific provisions containing additions and
modifications to the general rules. However, where a direct conflict exists between a provision
of Title 1 and a provision of any other Title, the other Title will govern the matter.34
21
22
23
24
25
26
27
28
29
30
31
32
33
34
TEX. REV. CIV. STAT. ANN. art. 1396-1 (Vernon Supp. 2008) (hereinafter TNPCA).
TEX. REV. CIV. STAT. ANN. art. 1302 (Vernon Supp. 2008) (hereinafter TMCLA).
TEX. REV. CIV. STAT. ANN. art. 1528n (Vernon Supp. 2008) (hereinafter LLC Act).
TEX. REV. CIV. STAT. ANN. art. 6132b (repealed 1999) (hereinafter TRPA).
TEX. REV. CIV. STAT. ANN. art. 6132a-1 (Vernon Supp. 2008) (hereinafter TRLPA).
TEX. REV. CIV. STAT. ANN. art. 6138A (Vernon Supp. 2008) (hereinafter TREITA).
TEX. REV. CIV. STAT. ANN. art. 1396-1B (Vernon Supp. 2008) (hereinafter TUUNA).
TEX. REV. CIV. STAT. ANN. art. 1528e (Vernon Supp. 2008) (hereinafter TPCA).
TEX. REV. CIV. STAT. ANN. art. 1528f (Vernon Supp. 2008) (hereinafter TPAA).
TEX. REV. CIV. STAT. ANN. art. 1396-1A (Vernon Supp. 2008) (hereinafter TCAA).
TEX. BUS. ORG. CODE ANN. § 2.003 (Vernon 2008) (hereinafter TBOC § 2.003).
TBOC § 23.001.
TBOC § 402.005. Note that the Texas Finance Code has been amended by H.B. 1962 to provide that bank
associations and trust companies organized after January 1, 2006 are governed by the TBOC. Tex. H.B.
1962
Sections
12,
68,
80th
Leg.,
R.S.
(2007),
available
at
http://www.legis.state.tx.us/tlodocs/80R/billtext/pdf/HB01962F.pdf.
TBOC § 1.106(c).
5
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4.
Effective Date
The TBOC became effective on January 1, 2006 and applies to all domestic entities either
organized in Texas or resulting from a conversion that takes effect on or after that date.35
Domestic entities already in existence on January 1, 2006 will continue to be governed by then
existing entity statutes until January 1, 2010,36 at which time the old laws will be repealed.
However, such entities may elect to be governed by the TBOC prior to that date by making a
filing with the Secretary of State of Texas and amending their governing documents as
necessary.37
5.
Changes Made By the TBOC
The TBOC, which had been under development since 1995, was a joint project of the
Business Law Section of the State Bar of Texas, the office of the Texas Secretary of State and
the Texas Legislative Council,38 and was passed with the endorsement and strong support of the
Texas Business Law Foundation. In the codification process, the general objective was not to
make substantive revisions to the existing Texas statutes. However, the TBOC did change the
form and procedures of many of the existing provisions and some substantive changes did occur.
Some of the more general changes, as well as basic transition and construction provisions, are
summarized below. Other changes that are more entity-specific are addressed in the appropriate
sections of this article.
(a)
Vocabulary
In an effort to streamline laws that govern business entities, the TBOC uses new terms to
denote concepts and filings that previously were common to many different entity types but
under different names. For example, each entity typically has a particular person or set of
persons which govern that type of entity. For limited partnerships, that person is the general
partner; for corporations, it is the board of directors; and for LLCs, it is either the managers or
members, as specified in the LLC’s formation documents. The TBOC replaces all those
different terms and simply refers to the persons or entities that control the main entity as that
entity’s “governing authority.”39 Similarly, the name of the document an entity must file to be
duly organized under Texas law is now simply called a “certificate of formation,” whereas
previously each entity had its own name for such document.40 One other significant vocabulary
change is that the Regulations of a limited liability company are now referred to as its “Company
Agreement.”41 Other changes include the shift in the titles of filings from “Application for
35
36
37
38
39
40
41
TBOC § 402.001(a).
TBOC § 402.005.
TBOC § 402.003.
Codification Comm. Report, supra note 19. The Bar Committee was primarily responsible for drafting the
TBOC in collaboration with the Secretary of State and the Texas Legislative Council.
TBOC § 1.002(35).
TBOC § 1.002(6). Comparable documents under pre-TBOC law include a corporation’s Articles of
Incorporation, an LLC’s Articles of Organization, and a limited partnership’s Certificate of Limited
Partnership.
See TBOC § 101.052.
6
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Certificate of Authority to Transact Business”42 to “Application for Registration,”43 from
“Articles of Amendment”44 to “Certificate of Amendment,”45 and from “Articles of
Dissolution”46 to “Certificate of Termination.”47 Under the TBOC, a “domestic entity” is a
corporation, partnership, LLC, or other entity formed under the TBOC or whose internal affairs
are governed by the TBOC,48 and a “foreign entity” is an organization that is formed under and
the internal affairs are governed by the laws of a jurisdiction other than Texas.49
(b)
Certificate of Formation
In addition to changing the name of the formation document required of entities
organizing in Texas, the TBOC has made small alterations to its required contents as well. For
example, previously such a document had to state the entity’s period of duration. The TBOC
eliminates this requirement, except for entities that will not exist perpetually.50 However, it adds
the requirement that the document state what type of entity shall be formed upon its filing.51
Other requirements differ slightly for each entity.52
(c)
Filing procedures
In addition to changing the form of the document required to organize a Texas business
entity, the TBOC streamlines the filing fees for a number of documents.53 For example, the
filing fees for a certificate of formation for all domestic entities are now set forth in TBOC
Chapter 4, Subchapter D.54 Additionally, the TBOC now authorizes a filing fee of $50 for the
pre-clearance of any document, whereas before, the Secretary of State was only authorized to
charge such fee for pre-clearance of limited partnership documents.55 Another procedural
change is that previously, when certain entities sent in their formation document (i.e., articles of
incorporation for a regular corporation), the Secretary of State would send back an official
document in response (i.e., a certificate of incorporation).56 Now, however, upon receipt of a
certificate of formation, the Secretary of State may simply return a written acknowledgement of
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
See TBCA art. 8.01.
See TBOC § 9.004.
See TBCA art. 4.04.
See TBOC § 3.053.
See TBCA art. 6.06.
See TBOC § 11.101.
TBOC § 1.002(18).
TBOC § 1.002(28).
TBOC §§ 3.003, 3.005, and the related Revisor’s Report, supra note 10.
TBOC § 3.005 and the related Revisor’s Report, supra note 10.
TBOC § 3.005 provides the minimum requirements for all Certificates of Formation, and the sections
immediately thereafter specify the additional information required for each type of entity.
See TBOC Chapter 4, Subchapter D.
See Id., and the related Revisor’s Report, supra note 10.
TBOC § 4.151 and the related Revisor’s Report, supra note 10.
See TBCA art. 3.03.
7
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the filing, and is not required to issue any additional certificates or documents.57 Filings are
generally effective when filed, not when the Secretary of State acknowledges them.58
Additionally, documents with delayed effective dates may now be abandoned at any time prior to
effectiveness.59
(d)
Entity Names
The TBOC relaxes the requirements for indicating the business entity form in the entity’s
official name further than even the most recent revisions to pre-TBOC law. A business’s name
must still indicate the business’s entity form, but with greater flexibility regarding placement and
abbreviation thereof than was previously permitted.60 For example, previously, a limited
partnership had to include in its name “limited,” “limited partnership,” “L.P.,” or “Ltd.,” and the
name could not contain the name of a limited partner except under limited circumstances.61
Now, however, limited partnerships need only contain “limited,” “limited partnership,” or “an
abbreviation of that word or phrase” in their names, without any restrictions on the inclusion of a
limited partner’s name.62
(e)
Governance
Subject to contrary provisions in an entity’s governing documents, the TBOC now
permits the removal of officers with or without cause, doing away with the requirement in much
of the source law that such removal must be in the entity’s best interests.63 Also, the TBOC
extends to all types of domestic entities, the right for officers and directors to rely on opinions,
reports, and statements given by certain people in the execution of their duties.64 Further, it
clarifies, as a default rule, that governing persons of domestic entities, other than limited
partnerships, have the right to inspect the entity’s books and records in connection with their
duties.65
Additionally, the TBOC expands the permissible methods of holding required meetings
to encompass the broad spectrum of technology now available by which such meetings may be
conducted.66 Moreover, it adds safeguards that must be followed when using such technology to
assure that only authorized persons are able to vote at such meetings.67
57
58
59
60
61
62
63
64
65
66
67
See TBOC § 4.002 and the related Revisor’s Report, supra note 10.
TBOC § 4.051.
TBOC § 4.057.
See TBOC §§ 5.054–.063.
TRLPA § 1.03.
TBOC §§ 5.055, 153.102, and the related Revisor’s Report, supra note 10.
TBOC § 3.104; TBCA art. 2.43; TNPCA art. 1396–2.21.
TBOC § 3.102. This default right previously existed for certain entities (see, e.g., TBCA 2.41D and
TNPCA art. 1396-2.28(B)), but not for partnerships or LLCs. See TBOC § 3.102, and the related Revisor’s
Report, supra note 10.
TBOC § 3.152, and the related Revisor’s Report, supra note 10.
See TBOC § 6.002.
TBOC § 6.002.
8
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(f)
Construction
The TBOC incorporates the provisions of the Code Construction Act68 to assist in its
interpretation.69 The Code Construction Act includes such useful aids as definitions of
commonly used terms, basic rules of construction, the order of authority for conflicting statutes,
and statutory savings provisions. The rules of the Code Construction Act are general in nature,
and are intended to fill in any gaps left by the more specific rules of construction provided within
the TBOC applicable to particular entity types.
(g)
Transition Rules70
As previously stated, during the transition period between January 1, 2006 and January 1,
2010, entities which were formed in Texas prior to the TBOC’s effective date but not opting in to
TBOC governance will continue to be governed by the old Texas statutes. During that period,
they may continue to make filings with the Texas Secretary of State in the same manner as
before the TBOC effective date, without any need to conform to the new filing requirements of
the TBOC or adjust the nomenclature used.71 However, limited liability partnerships are only
entitled to continue following the registration requirements of the TRPA and TRLPA until their
current registrations expire,72 at which point they must renew under the TBOC (although until
January 1, 2010 they will continue to be substantively governed by the TRPA and TRLPA).
D.
Federal “Check-the-Box” Tax Regulations
1.
Classification
Under the IRC, and the associated Treasury regulations promulgated, an unincorporated
business entity may be classified as an “association” taxable as a corporation, and subject to
income taxes at the corporate level ranging from 15% to 35% of taxable net income, absent a
valid S-corporation status election, in addition to any taxation which may be imposed on the
owner as a result of distributions from the business entity. Alternatively, the entity may be
classified as a partnership, a non-taxable “flow-through” entity in which taxation is imposed only
at the ownership level. Finally, if it is a single-owner LLC, it may be disregarded as a separate
entity for federal income tax purposes.
For many years, the IRS classified business entities for purposes of federal income
taxation by determining whether an organization had more corporate characteristics than noncorporate characteristics. Thus, if an entity possessed more than two of the corporate
characteristics of continuity of life, centralization of management, limited liability, and free
68
69
70
71
72
TEX. GOV’T CODE ANN. § 311 (Vernon Supp. 2008).
TBOC § 1.051.
For more detailed rules governing the transition period, see TBOC Title 8.
To illustrate, a corporation that was incorporated in Texas prior to January 1, 2006 may still amend its
Articles of Incorporation by filing Articles of Amendment to its Articles of Incorporation, rather than a
Certificate of Amendment. The Articles of Amendment would only need to conform to the current version
of the Texas Business Corporation Act.
TBOC § 402.001(b).
9
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transferability of interest, it would be classified as a corporation for purposes of federal income
taxation. Effective January 1, 1997, the IRS adopted “the Check-the-Box” Regulations
discussed below, which effectively allow a partnership or LLC to elect whether to be taxed as a
corporation.
2.
Check-the-Box Regulations
On December 18, 1996 the IRS issued Treasury Regulations §§ 301.7701-1, -2, and -3
(the “Check-the-Box Regulations”), which became effective January 1, 1997 and completely
replaced the former classification regulations.73 Entities will now have the assurance of either
partnership or corporate classification under a set of default rules or the ability to make an
election to obtain the desired classification.74 Although the four factor technical analysis of the
IRS’s former classification regulations (“Former Classification Regulations”) has been
completely replaced, the IRS still requires certain prerequisites to be fulfilled prior to qualifying
under the default rules or making a valid election:75
(a)
Eligible Entities
Initially, the entity must be a “business entity” that is separate from its owners for federal
income tax purposes. A business entity is defined, in part, as any entity recognized for tax
purposes that is not classified as a trust under Treas. Reg. § 301.7701-4 or otherwise subject to
special treatment under the IRC (e.g., real estate mortgage investment conduits (“REMICs”)).76
The Check-the-Box Regulations do not provide a test for determining when a separate entity
exists. Rather, the Check-the-Box Regulations merely state that a separate entity may be created
by a joint venture or other contractual arrangement if the participants carry on a trade or business
and divide the resulting profits.77 Additionally, to be eligible for partnership classification, the
business entity must not be automatically classified as a corporation under the Check-the-Box
Regulations (e.g., domestic incorporated entities, life insurance companies and most entities
whose interests are publicly traded).78 Among the entities that the Check-the-Box Regulations
automatically classify as corporations are over 85 specific types of foreign business entities.79 A
business entity that meets the foregoing requirements is an “eligible entity” that need not make
an election if the entity meets the requirements of the default rules.80
(b)
The Default Rules
The default rules under Treas. Reg. § 301.7701-3(b)(1) provide that a domestic eligible
entity, that is not classified as a corporation, is a partnership if it has two or more members and is
disregarded as a separate entity if it has a single owner (i.e., treated as a sole proprietorship or
73
74
75
76
77
78
79
80
T.D. 8697, 1997-1 C.B. 215.
Treas. Reg. § 301.7701-3(a) (as amended in 2006).
§ 301.7701-3(a).
Id. § 301.7701-2(a), -4.
Id. § 301.7701-1(a)(2).
Id. § 301.7701-2.
Id. § 301.7701-2(b)(8)
Id. § 301.7701-3(a).
10
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division of the owner). Under Treas. Reg. § 301.7701-3(b)(2), a foreign eligible entity is (i) a
partnership if it has two or more members and at least one member has unlimited liability, as
determined solely by reference to the law under which the entity is organized, (ii) an association
taxable as a corporation if no member has unlimited liability, or (iii) disregarded as a separate
entity if it has a single owner with unlimited liability.
(c)
The Election Rules
An eligible entity that desires to obtain a classification other than under the default
classification rules, or desires to change its classification, may file an election with the IRS on
Form 8832 (Entity Classification Election).81 For example, an election will be necessary if a
domestic LLC with two or more members qualifies as an eligible entity and the owners desire
corporate classification, rather than the default partnership classification. The Treasury
Regulations require that each member of an entity, or any officer, manager, or member of the
entity who is authorized to make the election and who so represents under penalty of perjury,
sign Form 8832.82
(d)
Existing Entities
Under the Check-the-Box Regulations, the classification of eligible entities in existence
prior to the effective date of the regulations will be respected by the IRS if (i) the entity had a
reasonable basis83 for its claimed classification, (ii) the entity and all of the entity’s members or
partners recognized the federal income tax consequences of any change in the entity’s
classification within the 60 months prior to January 1, 1997, and (iii) neither the entity nor any
member had been notified in writing on or before May 8, 1996 that the entity’s classification was
under examination by the IRS.84 Therefore, unless an existing eligible entity elected to change
the classification claimed prior to January 1, 1997, the entity will be “grandfathered” and will not
be required to make an election to protect its classification. However, the one exception to this
rule is when a single owner entity previously claimed to be classified as a partnership.85 The
single owner entity will be disregarded as an entity separate from its owner and thus will be
treated as a sole proprietorship, or a branch or division of the owner.86 If an entity elects to
change its classification, there can be severe adverse consequences, and tax counsel should be
consulted.
3.
81
82
83
84
85
86
Former Classification Regulations
Id. § 301.7701-3(c).
Id. § 301.7701-3(g)(2).
The term “reasonable basis” has the same meaning as under I.R.C. § 6662, which addresses the accuracyrelated penalties. See I.R.C. § 6662 (West Supp. 2008). The “reasonable basis” standard is far from clear;
however, it is significantly stronger than “not frivolous” and may be at least as high a standard as “more likely
than not.” See American Bar Association Section of Taxation Committee on the Standards of Tax Practice,
Standards of Tax Practice Statement, 54 TAX LAW. 185, 189 (2000).
Treas. Reg. § 301.7701-3(h)(2).
Id. § 301.7701-3(b)(3).
Id. § 301.7701-3(f)(2).
11
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Prior to January 1, 1997, under former Treas. Reg. § 301.7701-2,87 the “Former
Classification Regulations,” an unincorporated organization would have been treated by the IRS
as an “association,” taxable as a corporation, if the organization had more corporate
characteristics than non-corporate characteristics. Thus, if an entity possessed more than two of
the four corporate characteristics, it would have been classified as a corporation for purposes of
federal income taxation; however, if it had two or less of the corporate characteristics, it would
be classified as a partnership. These four characteristics are still relevant today, for they may be
embodied in existing partnership and LLC agreements and may be encountered in drafts of new
documents based on old precedent for years to come. The following sections discuss the four
corporate characteristics:
(a)
Continuity of Life
An organization does not have continuity of life if the death, insanity, bankruptcy,
retirement, resignation, or expulsion of any member would cause a dissolution of the
organization (hereinafter, “Dissolution Event”).88 If the occurrence of a Dissolution Event
causes dissolution of the organization, continuity of life does not exist, even if the remaining
members have the ability to opt, by unanimous or majority consent, to continue the business.89
Some states, including Texas, allow the partners of a partnership or members of an LLC to
provide in the partnership agreement or articles of organization for a self-executing “right to
continue” the business in the event of a Dissolution Event.90 Despite the fact that such an
agreement constitutes the agreement of a majority of the members of the organization, the use of
any prior agreement to continue the business, by eliminating the possibility of dissolution upon a
Dissolution Event, may have created continuity of life and would have jeopardized the
87
88
89
90
Former Treas. Reg. § 301.7701-2 (1967) (codifying Morrissey v. Comm’r, 296 U.S. 344, 357–58 (1935)); see
BORIS I. BITTKER & JAMES S. EUSTICE, FEDERAL INCOME TAXATION OF CORPORATIONS AND SHAREHOLDERS
¶ 2.02 (5th ed. 1987) (discussing the classification of associations as corporations for federal income tax
purposes).
Former Treas. Reg. § 301.7701-2(b). A general or limited partnership formed under a statute corresponding
to the Uniform Partnership Act or the Uniform Limited Partnership Act was considered by the IRS to lack
continuity of life under Former Treas. Reg. § 301.7701-2(b).
Former Treas. Reg. § 301.7701-2(b). Until 1993, the Former Classification Regulations indicated that such a
partnership would avoid continuity of life only if a Dissolution Event resulted in either automatic dissolution
or dissolution unless all of the remaining partners agreed to continue the business. Thus, it was assumed that
a partnership would have the corporate characteristic of continuity of life if an agreement of a majority of the
remaining partners were sufficient to save the partnership from dissolution upon the occurrence of a
Dissolution Event. This belief was reinforced by Private Letter Ruling 90-100-27, in which the IRS,
considering an LLC’s tax status, ruled that “[b]ecause dissolution under the Act may be avoided by a majority
vote of members, rather than unanimous agreement, L possesses the corporate characteristic of continuity of
life.” I.R.S. Priv. Ltr. Rul. 90-10-027 (March 9, 1990). The IRS should have based its ruling on the
Regulations governing the LLC instead of the statute under which the LLC was formed, regardless of whether
a majority vote to continue the business was insufficient to preclude continuity of life. Ultimately, the Former
Classification Regulations were amended effective June 14, 1993 to allow “a majority in interest,” rather than
“all remaining members” of a partnership to elect to continue the business after a Dissolution Event. See Rev.
Rul. 93-91, 1983-2 C.B. 316; Rev. Proc. 95-10, 1995-1 I.R.B. 20 (confirming the applicability of this standard
to LLCs).
See, e.g., LLC Act arts. 3.02(9), 6.01(B); TBOC § 101.052.
12
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classification of the entity as a partnership for federal income tax purposes.91 Because continuity
of life is no longer relevant to determining whether an entity may be classified as a partnership
for federal income tax purposes, attorneys should consider whether Dissolution Events are
consistent with the business objectives of the parties, and, if they are not, consider means for
negating them in partnership and LLC agreements.
(b)
Centralization of Management
For this corporate characteristic to be present, the exclusive and continuing power to
make necessary management decisions must be concentrated in a managerial group, composed
of less than all the members, that has the authority to act on behalf of the organization
independently of its members.92 The key to this characteristic is the group’s ability to bind the
entity in its role as a representative of the organization, as opposed to its role as an owner.
(c)
Limited Liability
An organization has the corporate characteristic of limited liability if under local law no
member is personally liable for the debts or obligations of the organization when the
organization’s assets are insufficient to satisfy such debts or obligations.93 In the case of a
limited partnership, the IRS deemed the entity to have limited liability where the general partner
has no substantial assets, other than his interest in the partnership, that could be reached by
creditors of the entity and the general partner is merely a “dummy” acting as agent of the limited
partners.94 To negate the characteristic of limited liability under the Former Classification
Regulations, tax lawyers advised that the general partner should have substantial assets. The
capitalization of the general partner is of reduced importance from a tax standpoint under the
Check-the-Box Regulations.95
(d)
91
92
93
94
95
Free Transferability of Interest
See I.R.S. Priv. Ltr. Rul. 90-30-013 (Apr. 25, 1990) (explaining “no right to continue the business of X upon a
[Dissolution Event] is stated in the articles of organization apart from continuance of X’s business upon the
consent of all the remaining members. Therefore, if a member of X ceases to be a member of X for any
reason, the continuity of X is not assured, because all remaining members must agree to continue the business.
Consequently, X lacks the corporate characteristic of continuity of life.”); see also I.R.S. Priv. Ltr. Rul. 90-29019 (Apr. 19, 1990); I.R.S. Priv. Ltr. Rul. 89-37-010 (June 16, 1989); Former Treas. Reg. § 301.7701(b)(1)
(explaining “[a]n organization has continuity of life if the death, insanity, bankruptcy, retirement, resignation,
or expulsion of any member will not cause a dissolution of the organization.”). Arguably, if the members
have a preexisting agreement providing that such Dissolution Events will not cause a dissolution, then the
organization has continuity of life. It would appear that there must be some uncertainty about the continuation
of the business at the time of the Dissolution Event in order to avoid a finding of continuity of life.
Rev. Proc. 95-10, 1995-1 I.R.B. 20; Rev. Rul. 93-6, 1993-1 C.B. 229; see also BITTKER & EUSTICE, supra
note 87, at § 2.02.
Former Treas. Reg. § 301.7701-2(d)(1).
Former Treas. Reg. § 301.7701-2(d)(2).
In contrast to the Former Classification Regulations in the Former Treas. Reg. § 301.7701 and Rev. Proc.
89-12, 1989-7, I.R.B. 22, the Check-the-Box Regulations do not focus on the capitalization of the general
partner.
13
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The characteristic of free transferability of interest does not exist in a case where a
member can, without the consent of other members, assign only his right to a share in the profits
but cannot assign his rights to participate in the management of the organization.96 Free
transferability does not exist if, under local law, the transfer of a member’s interest results in the
dissolution of the old entity and the formation of a new entity.97 Partnership and LLC
agreements traditionally have contained provisions intended to negate free transferability by
giving a general partner or manager the discretion to decide whether to approve a proposed
transfer.98 These provisions are no longer appropriate except to the extent necessary to achieve
the party’s business objectives or to facilitate compliance with securities laws.
E.
Texas Entity Taxation
1.
Corporations and LLCs, but not Partnerships, Subject to Pre-2007
Franchise Tax
Through December 31, 2006 corporations and LLCs were subject to the former version
of the Texas franchise tax,99 which was equal to the greater of (i) 0.25% of its “taxable capital”
(generally owners’ equity) and (ii) 4.5% of its “net taxable earned surplus.” “Net taxable earned
surplus” was computed by determining the entity’s reportable federal taxable income, adding to
that amount the compensation of officers and directors. The add-back was not required if (x) the
corporation had not more than 35 shareholders or was an S-corporation for federal tax purposes
with no more than 75 shareholders,100 or (y) the LLC has not more than 35 members.101 The
result was apportioned to Texas based on the percentage of its gross receipts from Texas sources.
Although labeled a “franchise tax,” the tax on “net taxable earned surplus” was really a 4.5%
income tax levied at the entity level.
Limited and general partnerships (including the LLP) were not subject to the former
franchise tax. The Texas Comptroller of Public Accounts (“Comptroller”) had issued private
letter rulings stating that it would honor the state law classification of an entity as a partnership,
despite any Check-the-Box election by the partnership to be treated as a corporation for federal
income tax purposes.102
2.
96
97
98
99
100
101
102
Franchise Tax Change Proposals
Former Treas. Reg. § 301.7701-2(e)(1); see also Act of May 9, 1961, 57th Leg., R.S., ch. 158, 1961 Tex. Gen.
Laws 289; Act of May 17, 1979, 66th Leg., R.S., ch. 723, § 5, 1979 Tex. Gen. Laws 1782; Act of May 9,
1985, 69th Leg., R.S., ch. 159, § 76, 1985 Tex. Gen. Laws 692; Act of May 9, 1991, 72d Leg., R.S., ch. 901,
§§ 83–85, 1991 Tex. Gen. Laws 3234–35; Act of May 31, 1993, 73d Leg., R.S., ch. 917, § 2, 1993 Tex. Gen.
Laws 3912–13 (expired Jan. 1, 1999).
Former Treas. Reg. § 301.7701-2(d)(2).
In contrast to the Former Classification Regulations and Revenue Procedure 89-12, the Check-the-Box
Regulations do not focus on the capitalization of the general partner.
TEX. TAX CODE § 171.001 (Vernon 2002 and Supp 2004).
TEX. TAX CODE § 171.110(b) (Vernon 2002 and Supp 2004).
34 TEX. ADMIN. CODE § 3.558(b)(10) (2002).
See e.g., Comptroller Taxpayer Response Letter Accession No. 9811328L (Nov. 30, 1998).
14
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Efforts to reduce Texas’ dependence on property taxes to fund the schools led the 1997
through 2005 Texas Legislatures to consider, but not adopt, proposed changes in the Texas tax
system which would subject partnerships to the franchise tax.103 The 2005 Texas Legislature
also proposed: (i) a payroll based tax; and (ii) an extension of the Texas franchise tax to foreign
corporations earning Texas source income from Texas based partnerships. In 2006, property tax
reform efforts were primarily motivated by the Texas Supreme Court’s decision in Neeley v.
West Orange-Cove Consolidated Independent School District, 176 S.W.3rd 746 (Tex. 2005).
The Court in West Orange-Cove held that the property tax rate cap then in effect of $1.50 per
$1,000 of valuation violated article VIII section 1-e of the Texas Constitution, which prohibits
the imposition of a statewide property tax. The Court directed the Texas Legislature to cure the
defect by June 1, 2006. In anticipation of a Supreme Court decision in West Orange-Cove, on
November 4, 2005 Governor Rick Perry appointed a 24-member Texas Tax Reform Commission
and former Comptroller John Sharp as its Chairman (the “Sharp Commission”) to study and
make recommendations on how to reform Texas’ business tax structure and provide significant
property tax relief and also to later address court-mandated changes in how Texas funds its
schools. On November 21, 2005 (the day before the Supreme Court decision in West OrangeCove), the Sharp Commission held the first of a series of public hearings at which various
affected parties testified as to what should be changed. On March 29, 2006, the Sharp
Commission released its report (the “Sharp Commission Report”) which recommended that (1)
the Legislature should cut school district property taxes for maintenance and operations
substantially (with many districts setting rates at or near $1.50 per $100 of valuation, the Sharp
Commission recommended that the property tax rate should be lowered to $1 per $100 and
permanently re-capped at no more than $1.30 per $100 by the 2007 tax year and reductions for
103
See Tex. H.B. 3146, 78th Leg., R.S. (2003), available at http://www.legis.state.tx.us/home.aspx (select the
“78(R) - 2003” Legislature, select Bill Number, then fill in “HB 3146” in the space below). House Bill
3146 in the 2003 Legislative Session, by Representative Ron Wilson, attempted to amend the Texas Tax
Code to define “corporation” for franchise purposes as “every corporation, limited liability company,
limited partnership, business trust, real estate investment trust, savings and loan association, banking
corporation, and any other entity for which any of the owners have limited liability” and exclude, in the
case of a partnership, the distributive share of the partnership’s income or loss attributable to natural
persons. See also Tex. H.B. 3, 79th Leg., R.S. (2005), available at http://www.legis.state.tx.us/home.aspx
(select “79(R) - 2005” Legislature, select Bill Number, then fill in “HB 3” in the space below). House Bill
3, as passed by the House on March 14, 2005, would enact a Reformed Franchise Tax which would apply
to most business entities, including most corporations, LLCs and partnerships, and allow them to elect
either (i) 1.15% tax on Texas employee wages with no ceiling, or (ii) the existing franchise tax at the rate of
4.5% of net taxable earned surplus. In the event an unincorporated entity owned wholly or partially by
natural persons elects to be subject to the franchise tax, H.B. 3 requires that the business and those natural
persons agree pursuant to an election form that the taxable earned surplus of the business shall be
calculated without regard to any exclusion, exemption or prohibition set forth in Article 8, Section 24(a), of
the Texas Constitution (the “Bullock Amendment”), which effectively recognizes the applicability of the
Bullock Amendment to any form of income tax imposed on an unincorporated entity in which an interest is
owned by a natural person. On May 11, 2005, the Senate passed C.S. H.B. 3, which, like H.B. 3, would
include most corporations, LLCs and partnerships as “taxable entities,” and would allow the entities to elect
to be subject to either (1) a 1.75% tax on Texas employee wages up to a cap of $1,500 per employee, or (2)
a 2.5% business activity tax, which is similar to the current franchise tax plus all compensation exceeding
$30,000 per employee; in each case subject to a minimum tax of 0.25% of Texas gross receipts. Both the
House and Senate bills included additional sales and other consumption taxes, although there were
significant differences in the two bills. This tax legislation died in a Conference Committee at the end of
the 2005 Legislative Session.
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the 2006 tax year sufficient to comply with the Supreme Court’s mandate to be provided
immediately) and (2) the Legislature should reform the state’s franchise tax by (a) broadening
the base of businesses that pay into the system to include most entities whose owners are
generally protected from the entities’ liabilities, (b) cutting the franchise tax rate from 4.5% to
1%, (c) basing the franchise tax on a business’ margin by allowing each business to choose
between deducting either the cost of goods sold or employee or partner compensation (including
health insurance, pensions and other benefits) from its total revenue, and (d) increasing the
small-business exemption from $150,000 to $300,000 in total revenue and exempting sole
proprietors and “non-corporate general partnerships.” 104 The Sharp Commission Report also
recommended raising the tax on cigarettes by $1 per pack.
3.
Margin Tax
In a Special Session which convened on April 17, 2006 and adjourned sine die on May
15, 2006, the Texas Legislature passed House Bill 3 (“H.B. 3”).105 H.B. 3 amends Texas Tax
Code Chapter 171106 to replace the current franchise tax on corporations and LLCs with a new
and novel business entity tax called the “Margin Tax” herein. In the 2007 Legislative Session
the Margin Tax provisions of the Texas Tax Code were amended by H.B. 3928.
(a)
Who is Subject to Margin Tax
The Margin Tax is imposed on all businesses except (i) sole proprietorships, (ii) general
partnerships “the direct ownership of which is entirely composed of natural persons,” and (iii)
certain “passive” entities.107
Thus, corporations, limited partnerships, certain general
104
105
106
107
A draft of the legislation proposed by the Sharp Commission can be found at
http://www.ttrc.state.tx.us/files/tax_reform_bill.pdf.
Tex. H.B. 3, 79th Leg., 3d Called Sess. (2006); the text of H.B. 3 can be viewed in its entirety at the
following
link:
http://www.capitol.state.tx.us/cgibin/tlo/textframe.cmd?LEG=79&SESS=3&CHAMBER=H&BILLTYPE=B&BILLSUFFIX=00003&VER
SION=3&TYPE=B.
Chapter 171 of the Texas Tax Code was modified and largely replaced by the provisions of H.B. 3.
References in the following footnotes to the “Texas Tax Code” are references to Chapter 171 of the Texas
Tax Code as amended in 2006 by H.B. 3 and in 2007 by H.B. 3928 (“H.B. 3928”), available at
http://www.legis.state.tx.us/tlodocs/80R/billtext/pdf/HB03928F.pdf.
Texas Tax Code § 171.0002 defines “taxable entity” as follows:
Sec. 171.0002. DEFINITION OF TAXABLE ENTITY. (a) Except as otherwise provided by this section,
"taxable entity" means a partnership, limited liability partnership, corporation, banking corporation, savings
and loan association, limited liability company, business trust, professional association, business
association, joint venture, joint stock company, holding company, or other legal entity. The term includes a
combined group. A joint venture does not include joint operating or co-ownership arrangements meeting
the requirements of Treasury Regulation Section 1.761-2(a)(3) that elect out of federal partnership
treatment as provided by Section 761(a), Internal Revenue Code.
(b) "Taxable entity" does not include:
(1) a sole proprietorship;
(2) a general partnership:
(A) the direct ownership of which is entirely composed of natural persons; and
(B) the liability of which is not limited under a statute of this state or another state,
including by registration as a limited liability partnership;
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partnerships, LLPs, LLCs, business trusts and professional associations are subject to the Margin
Tax. The Margin Tax is not imposed on sole proprietorships, general partnerships that are
owned 100% by natural persons,108 certain narrowly defined passive income entities109
(3) a passive entity as defined by Section 171.0003; or
(4) an entity that is exempt from taxation under Subchapter B.
(c) "Taxable entity" does not include an entity that is:
(1) a grantor trust as defined by Sections 671 and 7701(a)(30)(E), Internal Revenue Code, all of
the grantors and beneficiaries of which are natural persons or charitable entities as described in Section
501(c)(3), Internal Revenue Code, excluding a trust taxable as a business entity pursuant to Treasury
Regulation Section 301.7701-4(b);
(2) an estate of a natural person as defined by Section 7701(a)(30)(D), Internal Revenue Code,
excluding an estate taxable as a business entity pursuant to Treasury Regulation Section 301.7701-4(b);
(3) an escrow;
(4) a real estate investment trust (REIT) as defined by Section 856, Internal Revenue Code, and
its "qualified REIT subsidiary" entities as defined by Section 856(i)(2), Internal Revenue Code, provided
that:
(A) a REIT with any amount of its assets in direct holdings of real estate, other than real
estate it occupies for business purposes, as opposed to holding interests in limited partnerships or other
entities that directly hold the real estate, is a taxable entity; and
(B) a limited partnership or other entity that directly holds the real estate as described in
Paragraph (A) is not exempt under this subdivision, without regard to whether a REIT holds an interest in
it;
(5) a real estate mortgage investment conduit (REMIC), as defined by Section 860D, Internal
Revenue Code;
(6) a nonprofit self-insurance trust created under Chapter 2212, Insurance Code, or a predecessor
statute;
(7) a trust qualified under Section 401(a), Internal Revenue Code; or
(8) a trust or other entity that is exempt under Section 501(c)(9), Internal Revenue Code.
(d) An entity that can file as a sole proprietorship for federal tax purposes is not a sole proprietorship for
purposes of Subsection (b)(1) and is not exempt under that subsection if the entity is formed in a manner
under the statutes of this state, another state, or a foreign country that limit the liability of the entity.
108
109
Since an LLP is classified under both the TRPA and the TBOC as a species of general partnership, under a
literal reading of H.B. 3 the Margin Tax would not have been applicable to an LLP composed solely of
natural persons. Various statements by the Sharp Commission and the offices of the Governor and the
Comptroller suggested that the Margin Tax was generally intended to apply to any entity that afforded
limited liability to its owners, which would include the LLP. H.B. 3928 resolved this issue by amending
Tex. Tax Code § 171.0002 to expressly provide that an LLP is subject to the Margin Tax.
Tex. Tax Code § 171.0003 defines “passive entity” as follows:
Sec. 171.0003. DEFINITION OF PASSIVE ENTITY. (a) An entity is a passive entity only if:
(1)
the entity is a general or limited partnership or a trust, other than a business trust;
(2)
during the period on which margin is based, the entity's federal gross income consists of
at least 90 percent of the following income:
(A) dividends, interest, foreign currency exchange gain, periodic and nonperiodic
payments with respect to notional principal contracts, option premiums, cash settlement or termination
payments with respect to a financial instrument, and income from a limited liability company;
(B) distributive shares of partnership income to the extent that those distributive shares
of income are greater than zero;
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(including certain real estate investment trusts (“REITs”)),110 grantor trusts,111 estates of a natural
person, an escrow,112 or a real estate mortgage investment conduit (“REMIC”).
(C) capital gains from the sale of real property, gains from the sale of commodities
traded on a commodities exchange, and gains from the sale of securities; and
(D) royalties, bonuses, or delay rental income from mineral properties and income from
other nonoperating mineral interests; and
(3)
the entity does not receive more than 10 percent of its federal gross income from
conducting an active trade or business.
(a-1)
In making the computation under Subsection (a)(3), income described by Subsection (a)(2) may
not be treated as income from conducting an active trade or business.
(b)
The income described by Subsection (a)(2) does not include:
(1)
rent; or
(2)
income received by a nonoperator from mineral properties under a joint operating
agreement if the nonoperator is a member of an affiliated group and another member of that group is the
operator under the same joint operating agreement.
110
111
As used in the definition of “passive entity,” Tex. Tax Code § 71.0004 defines “conducting active trade or
business” as follows:
Sec. 171.0004. DEFINITION OF CONDUCTING ACTIVE TRADE OR BUSINESS. (a) The
definition in this section applies only to Section 171.0003.
(b) An entity conducts an active trade or business if:
(1) the activities being carried on by the entity include one or more active operations that
form a part of the process of earning income or profit; and
(2) the entity performs active management and operational functions.
(c) Activities performed by the entity include activities performed by persons outside the entity,
including independent contractors, to the extent the persons perform services on behalf of the
entity and those services constitute all or part of the entity's trade or business.
(d) An entity conducts an active trade or business if assets, including royalties, patents,
trademarks, and other intangible assets, held by the entity are used in the active trade or business
of one or more related entities.
(e) For purposes of this section:
(1) the ownership of a royalty interest or a nonoperating working interest in mineral rights
does not constitute conduct of an active trade or business;
(2) payment of compensation to employees or independent contractors for financial or legal
services reasonably necessary for the operation of the entity does not constitute conduct of an
active trade or business; and
(3) holding a seat on the board of directors of an entity does not by itself constitute conduct of
an active trade or business.
The REIT exclusion is limited to REITs that do not directly own property (other than the real estate that the
REIT occupies for business purposes) and qualified REIT subsidiaries (which do not include partnerships).
Tex. Tax Code § 171.0002(a)(8).
An interpretative question under H.B. 3 is what types of “trusts” other than grantor trusts, might be
considered to be a “legal entity” as that term is used in connection with the definition of “taxable entity.”
The Texas Trust Code applies only to “express trusts.” An “express trust” is defined in the Texas Trust
Code as “a fiduciary relationship” with respect to property which arises as a manifestation by the settlor of
an intention to create the relationship and which subjects the person holding title to the property to
equitable duties to deal with the property for the benefit of another person.” Recently, the Texas Supreme
Court confirmed previous decisions that a trust is not an entity but a relationship. See e.g., “[t]he term
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(b)
Passive Entities
Passive entities must have at least 90% of their federal gross income113 from partnership
allocations from downstream non-controlled flow through entities, dividends, interest, royalties,
or capital gains from the sale of (i) real estate114 (ii) securities, or (iii) commodities. It is
important to note that real estate rentals as well as other rent and income from mineral interests
are not passive income sources unless they are classified as “royalties, bonuses, or delay rental
income from mineral properties and income from other nonoperating mineral interests.”115 In
addition, only non-business trusts, general partnerships and limited partnerships can qualify as
passive entities. LLCs and S-corps cannot qualify as passive entities, even if 90% of their
income is from qualifying passive sources.
A limited partnership that has income from real estate rents as well as dividends and
interest may want to consider whether the entity could be split in two in order to isolate the
passive income sources into an entity that will qualify as a tax exempt passive entity.116
New Comptroller Rule 3.582, effective January 1, 2008, mandates that an entity must be
the type of entity that may qualify to be passive (i.e., a partnership or trust, and not an LLC) for
the entire tax year at issue in order to qualify as passive for such year.117 So for example, if an
LLC with substantial real estate rents plans to convert to an LP for a year in which it will
liquidate a real estate asset, achieve a major capital gain, and possibly qualify as a passive entity,
the LLC will need to complete the conversion to an LP prior to January 1 of such year.
112
113
114
115
116
117
‘trust’ refers not to a separate legal entity but rather to the fiduciary relationship governing the trustee
with respect to the trust property.” Huie v. DeShazo, 922 S.W.2d 920, 926 (Tex. 1996) (holding that
treating trust rather than trustee as attorney’s client “is inconsistent with the law of trusts”). There is at
least a negative implication in the wording of H.B. 3, however, that trusts other than “grantor trusts” are
taxable entities. Further, a trust is an entity for federal income tax purposes (when a trust applies for a
taxpayer identification number, the name of the entity is the name of the trust – not the name of the trustee;
the taxpayer name used on a trust’s Form 1041 is the trust’s name).
Tex. Tax Code § 171.0002(c).
34 T.A.C. 3.582 (b)(3) defines federal gross income as: "Gross income as defined in Internal Revenue
Code, §61(a)."
There is some pending discussion of what definition of "real estate" will be used for this purpose. While
the Texas Comptroller has long standing definitions for "real estate" under the sales tax chapters of the
Texas Tax Code, there is some informal indication that the Internal Revenue Code's definition of real estate
is more appropriate for this purpose. See e.g. Treas. Reg. 1-897-1(b)(1)
Tex. Tax Code § 171.0003(a)(2)(D); see also Tex. Tax Code § 171.0003(b)(2) (passive income includes
“income received by a nonoperator from mineral properties under a joint operating agreement if the
nonoperator is [not] a member of an affiliated group and another member of that group is the operator
under the same joint operating agreement”).
H.B. 3 § 22 raises some question about whether or to what extent partnership divisions will be honored.
For example, H.B. 3 § 22(f) provides that when a partnership is divided into two or more partnerships the
resulting partnerships are treated as a “continuation of the prior partnership.” This does not apply to
partnerships owned 50% or less by the partners of the former partnership. See § 22 of Tex. H.B. 3, 79th
Leg., 3d Called Sess. (2006).
34 T.A.C. Section 3.582 (g) "Reporting requirement for a passive entity. If an entity meets all of the
qualifications of a passive entity for the reporting period, the entity will owe no tax; however, the entity
must file information to verify that the passive entity qualifications are met each year." (emphasis added).
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Passive entities are not part of combined groups, and the owners of passive entities are
not allowed to exclude income allocations from the passive entity.118 Rather, if the owners of a
passive entity are otherwise "taxable entities" they will have to re-test to determine their own
passive status. The income the owners receive from such a downstream passive entity may
qualify as passive source income,119 but the passive entity owner will still have to independently
pass the 90% passive source test.
(c)
LLPs
The 2007 Texas Legislature clarified (or expanded) the scope of the Margin Tax to apply
to LLPs, but the Comptroller has determined that LLPs can qualify to be passive entities if they
otherwise meet the 90% test for passive revenue.120
(d)
Prior Chapter 171 Exemptions
The Margin Tax preserves the exemptions previously available under the Texas franchise
tax for “an entity which is not a corporation but that because of its activities, would qualify for a
specific exemption … if it were a corporation” to the extent it would qualify if it were a
corporation.121
(e)
Small Business Phase-In
Taxable entities that have $300,000 (with CPI adjustments for later years) or less in gross
revenue in a year, or whose Margin Tax liability is less than $1,000, are exempt for that year.122
Taxable entities that have less than $900,000 in gross revenue123 in a year become subject to the
Margin Tax on the following schedule:
118
119
120
121
122
123
0 > $300K
100% discount
$300K>$400K
80% discount
$400K>$500K
60% discount
$500K>$700K
40% discount
$700K>$900K
20% discount
34 T.A.C. Section 3.587(c)(4) "A taxable entity will include its share of net distributive income from a
passive entity, but only to the extent the net income of the passive entity was not generated by any other
taxable entity."
34 T.A.C. Section 3.582(c)(2)(B) "[passive income includes] distributive shares of partnership income"
34 T.A.C. Section 3.582(c)(1)(C).
See e.g., Tex. Tax Code § 171.088.
Tex. Tax Code § 171.0002(d)(2).
Tex. Tax Code Section § 171.0021.
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(f)
Basic Calculation
In a nutshell, the calculation of the Margin Tax is based on a taxable entity’s (or unitary
group’s) gross receipts after deductions for either (x) compensation or (y) cost of goods sold
(“COGS”). An affiliated group must choose one type of deduction to apply to the entire group.
The “tax base” is apportioned to Texas using a single-factor gross receipts apportionment
formula with no throwback rule – Texas gross receipts divided by aggregate gross receipts. The
tax rate applied to the Texas portion of the tax base is 1% for all taxpayers except a narrowly
defined group of retail and wholesale businesses which pay a 0.5% rate. There is a safety net so
that the “tax base” for the Margin Tax may not exceed 70% of a business’s total revenues.124
However, it is possible for an entity to owe Margin Tax in any given year even if it is reporting a
loss for federal income tax purposes and has a negative cash flow.
Entities would pay the Margin Tax on a “unitary combined basis” (i.e., affiliated groups
of entities would in effect be required to pay taxes on a consolidated basis). Thus, the internal
partnership structure described below under the heading “7. Internal Partnerships Will Not Work
Under Margin Tax” would no longer work as described.
(g)
Gross Revenue Less (x) Compensation or (y) Cost of Goods Sold
For purposes of the Margin Tax, a taxable entity’s total revenue is generally total income
as reported on IRS Form 1120 (for corporate entities),125 or IRS Form 1065 (for partnerships and
other pass-through entities),126 plus dividends, interest, gross rents and royalties, and net capital
gain income,127 minus bad debts, certain foreign items, and income from related entities to the
extent already included in the margin tax base.128
(h)
Gross Revenue
H.B. 3 includes a very short and specific list of “flow through” items which are excluded
from gross receipts: (A) flow-through funds that are mandated by law or fiduciary duty to be
distributed to other entities (such as sales and other taxes collected from a third party and
remitted to a taxing authority); 129 (B) the following flow-through funds that are required by
contract to be distributed to other entities: (i) sales commissions paid to non-employees
(including split-fee real estate commissions);130 (ii) subcontracting payments for “services, labor,
or materials in connection with the actual or proposed design, construction, remodeling, or repair
of improvements on real property or the location of the boundaries of real property”;131 and (iii)
124
125
126
127
128
129
130
131
See generally Tex. Tax Code § 171.101.
Tex. Tax Code § 171.1011(c)(1).
Tex. Tax Code § 171.1011(c)(2).
Tex. Tax Code § 171.1011(c)(1)(A).
Tex. Tax Code § 171.1011(c)(1)(B).
Tex. Tax Code § 171.1011(f).
Tex. Tax Code § 171.1011(g)(1).
Tex. Tax Code § 171.1011(g)(3). Payments to subcontractors (apart from very limited express exclusions)
are not excludable from gross receipts for Margin Tax calculations. Thus if a client specifically engaged an
accounting firm in Texas to hire other accounting firms and pay for tax filings in other states or countries
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law firms may exclude the amounts they are obligated to pay over to clients and referring
attorneys, matter specific expenses, and pro-bono out-of-pocket expenses not to exceed $500 per
case;132 (C) the federal tax basis of securities and loans underwritten or sold;133 (D) lending
institutions may exclude loan principal repayment proceeds;134 (E) dividends and interest
received from federal obligations;135 (F) reimbursements received by a “management
company”136 for specified costs incurred in its conduct of the active trade or business of a
managed entity, including wages and compensation; and (G) payments received by a staff
leasing services company from a client company for wages, payroll taxes on those wages,
employee benefits, and workers’ compensation benefits for the assigned employees of the client
company.137
Health care providers138 may generally exclude payments received under the Medicaid,
Medicare, Children’s Health Insurance Program (“CHIP”), workers’ compensation, the
TRICARE military health system, the Indigent Health Care and Treatment Act, as well as the
132
133
134
135
136
137
138
and include the amount in the Texas accountant’s bill as a reimbursable expense, the expense
reimbursement would be included in the Texas accounting firm’s gross receipts. The consequence is the
Texas firms will increasingly ask their clients to pay significant out of pocket expenses directly.
Tex. Tax Code § 171.1011(g-3) allows legal service providers to exclude flow-through receipts as follows:
A taxable entity that provides legal services shall exclude from its total revenue:
(1) to the extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), the following flowthrough funds that are mandated by law, contract, or fiduciary duty to be distributed to the claimant by the
claimant's attorney or to other entities on behalf of a claimant by the claimant's attorney:
(A) damages due the claimant;
(B) funds subject to a lien or other contractual obligation arising out of the
representation, other than fees owed to the attorney;
(C) funds subject to a subrogation interest or other third-party contractual claim; and
(D) fees paid an attorney in the matter who is not a member, partner, shareholder, or
employee of the taxable entity;
(2) to the extent included under Subsection (c)(1)(A), (c)(2)(A), or (c)(3), reimbursement of the
taxable entity's expenses incurred in prosecuting a claimant's matter that are specific to the matter and that
are not general operating expenses; and
(3) $500 per pro bono services case handled by the attorney, but only if the attorney maintains
records of the pro bono services for auditing purposes in accordance with the manner in which those
services are reported to the State Bar of Texas.
Tex. Tax Code §§ 171.1011(g)(2) and 171.1011(g-2).
Tex. Tax Code § 171.1011(g-1).
Tex. Tax Code §§ 171.1011(m). “Federal obligations” are defined in Tex. Tax Code § 171.1011(p)(1) to
include stocks and other direct obligations of, or obligations unconditionally guaranteed by, the U.S. and
U.S. government agencies.
Tex. Tax Code §§ 171.1011(m)(1). “Management company” is defined in Tex. Tax Code § 171.1001(11)
as any limited liability entity that conducts all or part of the active trade or business of another entity in
exchange for a management fee and reimbursement of specified costs.
“Staff leasing company” for these purposes has the meaning set forth in § 91.001 of the Texas Labor Code.
“Health care providers” are defined in Tex. Tax Code § 171.1011(p)(3) as a taxable entity that participates
in the Medicaid program, Medicare program, Children’s Health Insurance Program (“CHIP”), state
workers’ compensation program, or TRICARE military health system as a provider of health care services.
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actual costs of “uncompensated care.”139 Health care institutions140 may exclude 50%141 of the
public reimbursement program revenues described above. Rulemaking by the Comptroller will
be important with respect to these exclusions, because there are currently no means by which to
trace Medicare funds to the actual service providers.
Any taxable entity may exclude revenues received from oil or gas produced during dates
certified by the Comptroller from (1) an oil well designated by the Railroad Commission of
Texas or similar authority of another state whose production averages less than 10 barrels a day
over a 90-day period; and (2) a gas well designated by the Railroad Commission of Texas or
similar authority of another state whose production averages less than 250 mcf a day over a 90day period.142 The Comptroller is required to certify dates during which the monthly average
closing price of West Texas Intermediate crude oil is below $40 per barrel and the average
closing price of gas is below $5 per MMBtu, as recorded on the New York Mercantile Exchange
(NYMEX).143
(i)
The Compensation Deduction
For purposes of the Margin Tax, “compensation” includes “wages and cash
compensation” as reported on the Medicare wages and tips box of IRS Form W-2. It also
includes “net distributive income” from partnerships, limited liability companies, and S
Corporations to natural persons,144 plus stock awards and stock options as well as workers
compensation benefits, health care, and retirement to the extent deductible for federal income tax
purposes.145 The deduction for wages and cash compensation may not exceed $300,000 plus
benefits that are deductible for federal income tax purposes for any single person.146
Compensation apparently does not include social security or Medicare contributions, and such
amounts apparently are not otherwise deductible for Margin Tax purposes.
(j)
The Cost of “Goods” Sold Deduction
Under the Margin Tax, “goods” means real or tangible personal property sold in the
ordinary course of business;147 the term does not include provision of services. As a result, most
service businesses (e.g., accounting, law and engineering firms) will not have a cost of goods
sold and are relegated to sole reliance on the compensation deduction.
139
140
141
142
143
144
145
146
147
Tex. Tax Code § 171.1011(n).
Tex. Tax Code § 171.1011(p)(2). “Health care institutions” are defined to include ambulatory surgical
centers; assisted living facilities licensed under Chapter 247 of the Health and Safety Code; emergency
medical service providers; home and community support services agencies; hospices; hospitals; a hospital
system; an certain intermediate care facilities for mentally retarded persons; birthing centers; nursing
homes; end stage renal facilities; and pharmacies.
Tex. Tax Code § 171.1011(o).
Tex. Tax Code § 171.1011(r).
Tex. Tax Code § 171.1011(s).
Tex. Tax Code § 171.1013(a)(1) & (2).
Tex. Tax Code § 171.1013(a)(3).
Tex. Tax Code § 171.1013(c).
Tex. Tax Code § 171.1012(a)(1).
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The term “cost of goods sold” is defined to include the direct costs of acquiring or
producing goods, including labor costs, processing, assembling, packaging, inbound
transportation, utilities, storage, control storage licensing and franchising costs, and production
taxes.148 Certain indirect costs for production facilities, land and equipment, such as
depreciation, depletion, intangible drilling and dry hole costs, geological and geophysical costs,
amortization, renting, leasing, repair, maintenance, research, and design are also included.149
The “cost of goods sold” definition does not include selling costs, advertising, distribution and
outbound transportation costs, interest or financing costs, income taxes or franchise taxes.150 Up
to 4% of administrative and overhead expenses may be included in “cost of goods sold” to the
extent they are allocable to the costs of acquiring or producing goods.151 The “cost of goods
sold” must be capitalized to the extent required by I.R.C. § 263A.152
(k)
Transition and Filing
The Margin Tax is being phased in commencing on January 1, 2007. The Texas
franchise tax remained in place for 2006, with the May 2007 tax payment based on business in
2006. The Margin Tax was effective January 1, 2007 and applies to business done after that
date; however, the May 2007 franchise tax payment was based on the old franchise tax for
business in 2006. The May 2008 Margin Tax payment is based on business in calendar year
2007.
Regular annual Margin Tax returns are due on May 15153 of each year, and are based on
financial data from the previous calendar year. The first Margin Tax returns are due on May 15,
2008,154 and they are based on financial data beginning January 1, 2007. For State revenue
estimating purposes, the 1000 largest businesses paying the Texas franchise tax were required to
file an information return with their franchise tax filing indicating what the taxpayer’s “Margin
Tax” liability would have been.155
(l)
Unitary Reporting
In another change from the franchise tax which did not provide for consolidated tax
reporting, the Margin Tax requires Texas businesses to file on a unitary and combined basis. An
affiliated group of entities in a “unitary business”156 must file a combined return including all
148
149
150
151
152
153
154
155
156
Tex. Tax Code § 171.1012(c).
Tex. Tax Code § 171.1012(c) and (d).
Tex. Tax Code § 171.1012(e).
Tex. Tax Code § 171.1012(f).
Tex. Tax Code § 171.1011(g).
Tex. Tax Code § 171.151(c).
See § 22 of Tex. H.B. 3, 79th Leg., 3d Called Sess. (2006).
See § 23 of Tex. H.B. 3, 79th Leg., 3d Called Sess. (2006)
Tex. Tax Code § 171.0001(17) defines a “unitary business” as “a single economic enterprise that is made
up of separate parts of a single entity or of a commonly controlled group of entities that are sufficiently
interdependent, integrated, and interrelated through their activities so as to provide a synergy and mutual
benefit that produces a sharing or exchange of value among them and a significant flow of value to the
separate parts.”
24
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taxable entities within the group.157 The unitary group includes all affiliates158 with a common
owner (i.e., greater than 50% owned),159 and the group includes entities with no nexus in
Texas.160
(m)
Combined Reporting
The Margin Tax statute literally applies its combined reporting standard of greater than
50% ownership to one or more "common owner or owners."161 The application of this standard
proved unworkable, and the Comptroller's Rule 3.590162 now limits the application of the
combined reporting requirement to entities with greater than 50% ownership or control held
directly or indirectly by a single owner. The only attribution rule applies to interests owned or
controlled by a husband and wife.163
Comptroller Rule 3.590 includes the following examples of determining the scope of an
affiliated group:
“(i) Corporation A owns 10% of Corporation C and 60% of Corporation
B, which owns 41% of Corporation C. Corporation A has a controlling interest in
Corporation B and a controlling interest in Corporation C of 51% of stock
ownership because it has control of the stock owned by Corporation B.
(ii) Corporation A owns 10% of Limited Liability Company C and 15%
of Corporation B, which owns 90% of Limited Liability Company C.
157
158
159
160
161
162
163
Comptroller Rule 3.590 (6) (effective January 1, 2008) defines "Unitary business" as: "A single economic
enterprise that is made up of separate parts of a single entity or of a commonly controlled group of entities
that are sufficiently interdependent, integrated, and interrelated through their activities so as to provide a
synergy and mutual benefit that produces a sharing or exchange of value among them and a significant flow
of value to the separate parts. In determining whether a unitary business exists, the comptroller shall
consider any relevant factor, including: (A) whether:
(i) activities of the group members are in the same general line, such as manufacturing, wholesaling,
retailing of tangible personal property, transportation, or finance;
(ii) the activities of the group members are steps in a vertically structured enterprise or process, such as the
steps involved in the production of natural resources, including exploration, mining, refining, and
marketing; or
(iii) the members are functionally integrated through the exercise of strong centralized management, such
as authority over purchasing, financing, product line, personnel, and marketing.
(B) Other factors. In addition, the comptroller may consider other factors that may be applicable, including
guidelines in Supreme Court decisions that presume activities are unitary. All affiliated entities are
presumed to be engaged in a unitary business.
Tex. Tax Code § 171.1014.
Section 171.0001(1) of the Tax Code defines an “affiliated group” as “a group of one or more entities in
which a controlling interest is owned by a common owner or owners, either corporate or noncorporate, or
by one of more of the member entities.” [emphasis added]
Tex. Tax Code § 171.0001(8).
See Tex. Tax Code § 171.1014(c).
Tex. Tax Code Section 171.0001(1).
34 T.A.C. Section 3.590 (Effective January 1, 2008).
34 T.A.C. Section 3.590 (b)(4)(E).
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Corporation A does not have controlling interest in Limited Liability Company C
and does not have a controlling interest in Corporation B. Corporation B has a
controlling interest in Limited Liability Company C.
(iii) Individual A owns 100% of 10 corporations, each of which owns
10% of Partnership B. Individual A has a controlling interest in each of the ten
corporations and in Partnership B.
(iv) Corporation A holds a 70% interest in Partnership B that owns 60%
of Limited Liability Company C. Corporation A owns the remaining 40% of
Limited Liability Company C. Corporation A owns a controlling interest in
Partnership B and a 100% controlling interest in Limited Liability Company
C.”164
The combined group does not include entities with 80% or more of their property and
payroll outside the United States.165 Passive entities or exempt entities are not part of the
group.166
The affiliated group is a single taxable entity for purposes of filing the Margin Tax return,
and the combined return is designed to be the sum of the returns of the separate affiliates. The
group must make an election to choose either the (i) cost of goods sold deduction; or (ii) the
compensation deduction for all of its members.167 In order to avoid double taxation, the
combined group may exclude items of total revenue received from a member of the group to the
extent such revenue is already in the tax base of an upper tier group member.168
(n)
Apportionment
The Margin Tax is apportioned using a single-factor gross receipt formula (Texas gross
receipts divided by aggregate gross receipts).169 Receipts that are excluded from the tax base
must also be excluded from gross receipts for apportionment purposes.170
Texas gross receipts includes receipts from the sale of tangible personal property
delivered or shipped to a buyer in this state, services performed in this state (regardless of
customer location), the use of a patent, copyright, trademark, franchise, or license in this state,
sale of real property in this state (including royalties from minerals) and other business done in
this state.171 Only Texas gross receipts from those entities within the group which have nexus in
Texas are included in the calculation of Texas receipts (this is sometimes referred to as the
164
165
166
167
168
169
170
171
Comptroller Rule 3.590.
Tex. Tax Code § 171.1014(a).
An affiliated group may elect to include an exempt entity that is not required to be included. See Tex. Tax
Code § 171.1014(g).
Tex. Tax Code § 171.1014(d).
Tex. Tax Code § 171.1014(c)(3).
Tex. Tax Code § 171.106(a).
Tex. Tax Code § 171.1055(a).
Tex. Tax Code § 171.103(a).
26
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“Joyce” rule).172 Sales to states in which the seller is not subject to an income tax are not
deemed to be a Texas receipt (i.e., no throwback rule).173
Aggregate gross receipts shall include the gross receipts (as described above) of each
taxable entity in the combined group without regard to whether an individual entity has nexus
with Texas.174 If a taxable entity sells an investment or capital asset, the taxable entity’s gross
receipts from its entire business for taxable margin includes only the net gain from the sale.175
(o)
Credits / NOL’s
Comptroller Rule 3.594 (effective January 1, 2008) describes the limited ability of a
taxpayer to utilize NOL's as a credit against the Texas margin tax. One initial qualification is
that any business losses upon which NOL's are based must have been used to offset any positive
amount of earned surplus even in years when no tax was due. In addition, taxpayers must submit
a notice of intent to preserve the right to claim the temporary credit for business loss
carryforwards with the first report due from a taxable entity after January 1, 2008, on a form
prescribed by the Comptroller. A taxable entity may only claim the credit if the entity was
subject to franchise tax on May 1, 2006. The of the right to claim the NOL credit may not be
transferred to another entity and changes to the membership of a combined group can prejudice
the right to utilize the NOL credit.
The election to claim the credit shall be made on each report originally due on or after
January 1, 2008 and before September 1, 2027. If a taxpayer is eligible to use its NOLs as a
Margin Tax credit, then for report years 2008 – 2017, the credit is the business loss carryforward
amount x 2.25% x 4.5%. For report years 2018 - 2027: the credit for the business loss
carryforward amount x 7.75% x 4.5%.
(p)
Administration and Enforcement
The Comptroller will have rulemaking authority with respect to the Margin Tax. The
former Comptroller, Carole Keeton Strayhorn, requested an Attorney General’s Opinion on
whether the new margin tax safely avoids classification as an income tax that could be in
violation of the Bullock amendment in the Texas Constitution.176
(q)
Effect of Margin Tax on Choice of Entity Decisions
The enactment of the Margin Tax changes the calculus for entity selections, but not
necessarily the result. The LLC has become more attractive for all business that are not likely to
ever qualify as exempt "passive entities" because an LLC can elect to be taxed as a corporation
172
173
174
175
176
Tex. Tax Code § 171.103(b).
See deletion from former Tex. Tax Code § 171.103(a)(1).
Tex. Tax Code § 171.105(c).
Tex. Tax Code § 171.105(b).
See “4. Constitutionality of Margin Tax” infra.
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or partnership for federal income tax purposes. However, the uncertainties as to an LLC’s
treatment for self employment purposes can restrict its desirability in some situations.177
4.
Constitutionality of Margin Tax
Proponents of the Margin Tax claim that it is not an income tax because its name and
deduction scheme differ from the income tax imposed by the IRC, although revenue, cost of
goods sold and other computations would be based on amounts from specified lines in a federal
income tax return, and it is imposed at the entity rather than the individual level. On August 3,
2006, however, the Financial Accounting Standards Board (“FASB”) found that the Margin Tax
is an income tax for the purposes of financial statements prepared in accordance with generally
accepted accounting principles for financial reporting in the U.S. (“GAAP”).178 Others also
disagree, particularly in the case of a partnership providing professional services (e.g.,
accounting, engineering, law or medical), and refer to Texas Constitution article 8, section 24(a)
(often referred to as the “Bullock Amendment”), which provides:
A general law enacted by the legislature that imposes a tax on the net incomes of
natural persons, including a person's share of partnership and unincorporated
association income, must provide that the portion of the law imposing the tax not
take effect until approved by a majority of the registered voters voting in a
statewide referendum held on the question of imposing the tax. The referendum
must specify the rate that will apply to taxable income as defined by law.
[Emphasis added]
Former Comptroller Strayhorn has written that portions of H.B. 3 are unconstitutional:
“Taxing income from partnerships is strictly prohibited by the Texas Constitution, and I believe
when this portion of H.B. 3 is challenged in court, the State will lose.”179 In a letter to the
Attorney General of Texas requesting a formal opinion180 whether H.B. 3 requires voter approval
under the Bullock Amendment, Comptroller Strayhorn wrote: 181
The literal wording of the Bullock Amendment is that a tax on the net income of
natural persons, including a person’s share of partnership or unincorporated
association income, must include a statewide referendum. The phrase “a person’s
share” logically modifies the words “income of natural persons” and read literally
and as an average voter would understand it, this provision would mean that,
177
178
179
180
181
See infra “V. Limited Liability Company – B. Taxation – 2. Other Tax Issues Relating to LLCs – (e) SelfEmployment Tax.”
See “5. Classification of Margin Tax Under GAAP,” infra.
Letter from Carole Keeton Strayhorn, Texas Comptroller of Public Accounts, to Rick Perry, Texas
Governor (May 2, 2006), http://www.cpa.state.tx.us/news/60502taxplan.pdf.
Letter from Barry McBee, First Assistant Attorney General, to Deirdre Delisi, the Chief of Staff of Texas
Governor Rick Perry (April 17, 2006) (on file with author) (stating that, “although a court may disagree,”
the Margin Tax would not be subject to the Bullock Amendment because it is an entity level tax). The
Comptroller’s request did not view the First Assistant Attorney General’s letter as an Attorney General
opinion.
Letter from Carole Keeton Strayhorn, Texas Comptroller of Public Accounts, to Greg Abbott, Texas
Attorney General (April 21, 2006) (on file with author).
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unless approved by the voters, no tax may be levied on any income that a person
receives from any unincorporated association. That interpretation is entirely
consistent with the caption and ballot language of SJR 49, which refer to a
prohibition against a “personal income tax.”
“A person’s share” of the income of an unincorporated association, whether it be
a limited partnership or a professional association, is determined first by the
agreement between the principals, and absent one, is governed by the statutes that
apply to those entities. The “share” does not have to be predicated on the “net
income” of the unincorporated association. However calculated or derived, the
share received by the natural person that becomes a part of his or her “net
income” cannot be taxed without voter approval, period.
An alternative interpretation of the partnership/unincorporated association proviso
for which supporters of the legislation may contend would read into the proviso
the word “net” so that, they would say, to trigger the referendum the tax would
have to be on a person’s share of partnership or unincorporated association “net
income.” In other words, under this much more restrictive interpretation, only a
tax on the net income of a partnership or unincorporated association, from which
a natural person received a share, would trigger the required referendum.
Interpolation of words into a constitutional provision should not be utilized where
it would defeat the overriding intent evidenced by the provision. Mauzy v.
Legislative Redistricting Board, 471 S. W. 2d 570 (Tex. 1971). Interpolation of
the word “net” in this proviso materially changes its meaning and would not be
consistent with the caption and ballot language. The electorate voted on whether
a personal income tax was to be approved by the Legislature without voter
approval, and nothing suggests that it is only taxation of “net income” of the
unincorporated association that was so objectionable as to require further voter
approval.
***
This provision means that if the tax is determined by deducting from gross
income any items of expense that are not specifically and directly related to
transactions that created the income, it is an income tax. And, if it is an income
tax, it is within the Bullock Amendment. Proposed Section 171.1012 (relating to
the cost of goods sold deduction) and 171.1013 (relating to the compensation
deduction) clearly include indirect and overhead costs of production and/or
compensation that make the margin tax an income tax under this preexisting
Texas definition found in Chapter 141, thereby invoking the Bullock Amendment.
***
Certainly it is the case that not all expenses are deducted under the margin tax
concept, and thus under some technical accounting definitions the margin tax
would not be on “net income” as that term is sometimes used in accounting
parlance ( i.e., the concluding item on an income statement). But the amendment
contains no link to accounting standards or definitions and it hardly could be said
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that an average voter in 1993 knew about, or cared about, the technicalities of
accounting definitions—no tax on his or her net income, including on income that
is received from partnerships or unincorporated associations, was what was being
prohibited, technicalities aside.
Proponents of the margin tax will no doubt assert that the margin tax does not
invoke Article VIII, Sec. 24(a) because the tax would be assessed against entities,
not against individuals, and particularly entities that under the law provide
liability insulating protection to their owners or investing principals just like
corporations. But as noted, the partnership/unincorporated association proviso of
the Bullock Amendment refers plainly and simply to “a person’s share” of the
income of an unincorporated association as triggering the referendum. Whether
the tax is directly on an entity is irrelevant if the only inquiry is whether there is
ultimately a tax levied on “a person’s share” of some distribution.
***
I believe the proposed margin tax would likewise require a referendum under
Article VIII, Sec. 24(a), precluding any adoption absent voter approval.
I also seek your opinion of whether the disparate tax rates found in this legislation
as proposed are permissible. As presently conceived, retailers and wholesalers
would pay the margin tax at the rate of ½ of 1 percent on their chosen tax base,
and all other taxable entities would pay at the rate of 1 percent.
An obvious issue is whether any rational basis exists for taxing retailers and
wholesalers at a rate substantially different from the rate that would apply to all
other businesses. I question whether this approach is valid based on fundamental
principles of equal treatment under the law.
As former Comptroller Strayhorn contended, the Bullock Amendment’s language
encompasses an income tax on a partnership interest attributable to a natural person, whether
imposed at the partnership or individual level, by its reference to “a person’s share of partnership
and unincorporated association income.” This plain language makes no distinction between
general partnerships, limited partnerships and limited liability partnerships, and applies even if
the partnership is viewed as a separate legal entity.182
Because the franchise tax exclusion for partnerships was a factor to be considered in
deciding whether to form a corporation, LLC or partnership, the enactment of the Margin Tax is
182
See Bishop v. District of Columbia, 401 A.2d 955 (D.C. 1979), in which the imposition of the District of
Columbia tax on unincorporated businesses at the partnership level was challenged by partners in District
of Columbia law firms who were residents of surrounding states on the basis that it was actually a
prohibited tax on the personal incomes of non-residents under the District of Columbia Home Rule Act,
D.C. CODE ANN. § l-206.02(a)(5), which prohibited a tax on the personal income of non-residents; the
District of Columbia Court of Appeals held that “as to the characterization of the tax, it is fundamental that
the nature and effect of the tax, not its label, determine if it is an income tax or not” and concluded that
“since the tax is on unincorporated business, [it] is therefore in reality a tax on the associates or partners
who run the business.”
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a material consideration in the entity selection analysis and removes one factor favoring
partnerships in a choice of entity analysis.
5.
Classification of Margin Tax Under GAAP
The Margin Tax is classified as an income tax in financial statements prepared in
accordance with GAAP.183 The minutes of its August 2, 2006 meeting reflect that FASB
decided not to add a project to its agenda that would provide guidance on whether the Margin
Tax is an income tax that should be accounted for in accordance with FASB Statement No. 109,
Accounting for Income Taxes, “because the tax is based on a measure of income.” These
minutes further reflect FASB’s TA&I Committee had “concluded that the [Margin] Tax was an
income tax that should be accounted for under Statement 109 and that there would not be
diversity in the conclusions reached by preparers, auditors, and regulators on whether the
[Margin] Tax was an income tax.”
6.
Internal Partnerships Will Not Work Under Margin Tax
Many Texas based corporations (whether or not incorporated in Texas) have utilized
internal limited partnerships to isolate liabilities and reduce franchise taxes. Because the Texas
franchise/income tax prior to the effectiveness of the Margin Tax was based upon federal taxable
income (computed on a separate company basis, for there has been no consolidation for Texas
franchise tax purposes), the corporate partner was subject to franchise taxes to the extent that its
distributive share of the partnership’s income (whether or not distributed) was Texas-sourced.184
183
184
See Peggy Fikac, “'Income tax' is a loaded label for business levy—Perry opponents get fired up after
accounting board calls it just that, (August 10, 2006), http://search.chron.com/chronicle/archiveSearch.do
(Type “Peggy Fikac” in the Author search box, then select date range of “August 10, 2006 to August 10,
2006”):
“A board that sets national accounting standards stirred up the Texas governor's race by
saying the state's new business tax is an income tax for reporting purposes. The decision
by the Financial Accounting Standards Board embraced a label rejected by backers,
including Republican Gov. Rick Perry, who championed the expanded business tax to
lower local school property taxes. The designation gives fresh fodder to Perry
challengers independent Carole Keeton Strayhorn, the state comptroller; independent
Kinky Friedman; and Democrat Chris Bell. Strayhorn spokesman Mark Sanders said the
ruling makes Perry the first governor in Texas history to sign into law an income tax.
Bell spokesman Jason Stanford said Perry managed ‘to pass not only the biggest tax
increase in state history but also apparently a state income tax with the singular
achievement of making sure that not one red cent will go to our public schools.’
Friedman campaign director Dean Barkley added a call for litigation, saying, ‘We urge
the business people of Texas to take this issue to the courts and test its legality.’ The
Texas Constitution bars a tax on people's income without a statewide vote. Perry
spokeswoman Kathy Walt and former state Comptroller John Sharp, a Democrat who
headed the blue-ribbon panel that recommended the tax, dismissed the significance of the
board's decision. ‘It is merely an instruction to accountants on how to fill out a form,’
said Walt, adding that Attorney General Greg Abbott ‘has ruled that it's not an income
tax. I'm going to take the attorney general's ruling, not the shrill tirade of the
comptroller.’ Abbott's top assistant, Barry McBee, Perry's former chief of staff, said in
an April letter that the tax didn't conflict with the state constitution. Strayhorn was
unsuccessful in seeking a formal opinion from Abbott.”
TEX. TAX CODE ANN. § 171.1032(c) (Vernon 2002 & Supp. 2004); Tex. SB 1125, 77th Leg., R.S. (2001).
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If the limited partnership were structured such that the Texas parent was a 1% general partner
and the 99% limited partner was incorporated in a state without an income tax (assume Nevada)
and did not otherwise do business or pay franchise taxes in Texas (the ownership of a limited
partner interest in a limited partnership doing business in Texas did not alone require the Nevada
corporate limited partner to qualify in Texas as a foreign corporation or to pay Texas franchise
taxes on its distributive share of the partnership’s income), the income attributable to the 99%
limited partnership interest would not be subject to the Texas franchise/income tax. If the
Nevada subsidiary subsequently dividended the income from the limited partnership to its Texas
parent, that dividend income was not subjected to the Texas franchise/income tax because either
the dividend was deducted in arriving at federal taxable income or it was a non-Texas receipt for
franchise tax purposes. The foregoing is a simplification of a common internal limited
partnership structure; the actual analysis, of course, was very fact specific and there were a
number of structure variations available depending upon the objectives and the source of the
income. Since the Margin Tax applies on a unitary and combined basis, the use of internal
partnerships has become less effective as an alternative for reducing Texas entity level taxes.
7.
Conversions
Though largely irrelevant under the Margin Tax, transforming a corporate entity into a
limited partnership structure previously was an expensive and time consuming procedure
because it required actual asset conveyances and liability assumptions, multiple entities
(typically including a Delaware or Nevada entity that must avoid nexus with Texas), and
consents of lenders, lessors and others. A simpler “conversion” method has evolved, utilizing
the Check-the-Box Regulations and the conversion procedures added in recent years to the
TBCA, the TRLPA and the TRPA.185 The conversion method required converting an existing
corporate entity subject to Texas franchise tax to a Texas limited partnership or LLP. The
converted entity then filed a Check-the-Box election to continue to be classified as a corporation
for federal income tax purposes. For federal income tax purposes, the conversion should qualify
as a nontaxable “F” reorganization. Thus, the entity ceased to be subject to Texas franchise tax
when the conversion became effective, but continued to be treated as the same corporate entity
for federal income tax purposes. The conversion method was suitable primarily for closely held
corporations. .
In Private Letter Ruling 2005 48021 (Dec. 2, 2005), the IRS found that an S corporation
to LLC conversion did not create a second class of stock because the operating agreement for the
LLC conferred identical rights on the members both as to distributions and liquidation.
Revenue Procedure 99-51,186 released by the IRS in December 1999, added an additional
note of caution to the practice of using Texas’ conversion statutes to convert an existing
corporation (with a valid S-corporation election but subject to Texas franchise taxes preconversion) into a limited partnership (with a Check-the Box election to be treated as a
corporation for federal tax purposes but not subject to Texas franchise taxes post-conversion).
The issue was whether the converted entity’s prior S-corporation election remains valid after its
metamorphosis into a state law limited partnership due to the IRC’s requirement that an electing
185
186
Infra Part “E. Business Combinations and Conversions - 2. Conversions.”
Rev. Proc. 99-51, 1999-52 I.R.B. 761 (December 27, 1999).
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S-corporation may have only one class of stock. In at least one private letter ruling issued by the
IRS prior to the publication of Revenue Procedure 99-51, the IRS sanctioned an S-corporation’s
conversion under state law to a limited partnership and acquiesced in continued S-corporation
election treatment where the taxpayer represented that general and limited partners had identical
rights under the partnership agreement to distributions and liquidating proceeds.187 However, in
Revenue Procedure 99-51 the IRS stated that (i) the IRS will no longer rule on the single class of
stock requirement in the limited partnership context until it studies the matter extensively and
issues further published administrative guidance and (ii) the IRS will treat any request for an
advance ruling on whether a state law limited partnership is eligible to elect S-corporation status
as a request for a ruling on whether the entity has a single class of stock. Failure to continue a
valid S-corporation election for a state law corporation converting to a state law limited
partnership taxed as a corporation for federal tax purposes would be treated for tax purposes as a
termination of the S election effective as of the end of the day preceding the date of conversion.
Until the IRS no-ruling policy is superseded, practitioners dealing with the conversion of existing
S-corporations to partnerships in order to avoid Texas entity taxes may want to consider the
alternative of using a subsidiary LLP (i.e., Checking-the-Box to be taxed as a corporation) in lieu
of a limited partnership, and specifically drafting equal, pro rata treatment of the partners in the
partnership agreement to overcome the single class of stock concern.
The applicability of the Margin Tax to limited partnerships removes conversions of
corporations to limited partnerships as a means of reducing Texas entity taxes. Conversions to
general partnerships, all of whose partners are individuals, remains a way to reduce Texas entity
taxes, but this possible tax savings comes with the cost of personal liability.
F.
Business Combinations and Conversions
1.
Business Combinations Generally
A business combination involves one entity or its owners acquiring another entity, its
assets or ownership interests. A business combination can be effected by a merger, acquisition
of shares or other ownership interests, or an acquisition of the assets of the acquired entity.
(a)
Merger
Texas law allows corporations, LLCs, and partnerships to merge with each other (e.g., a
limited partnership can merge into a corporation).188 Detailed provisions appearing in the TBOC
and its predecessor statutes provide the mechanics of adopting a plan of merger, obtaining owner
approval, filing with the Secretary of State, and protecting creditors.
(b)
Share Exchange
A business combination may be effected by a transfer of shares or other ownership
interests in which either (i) all of the owners agree to the sale or exchange of their interests, or
(ii) there is a statutory share or interest exchange pursuant to a plan of exchange approved by the
187
188
See e.g., Priv. Ltr. Rul. 1999-42-009 (July 16,1999).
TBCA art. 5.01, § A; LLC ACT art. 10.01, § A; TRLPA § 2.11; TRPA § 9.02; TBOC § 10.001.
33
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vote of the owners, which may be less than unanimous, but is binding on all, pursuant to statute
or the entity documents.189 The TBOC and its respective predecessor entity statutes—the TBCA,
the LLC Act, the TRLPA, and the TRPA—each have provisions providing the mechanics of
adopting a plan of exchange, obtaining owner approval, and filing with the Secretary of State.190
(c)
Asset Sale
A sale or exchange of all or substantially all of the assets of an entity may require
approval of the owners, depending on the nature of the transaction, the entity’s organization
documents, and applicable state law.191 In most states, shareholder approval of an asset sale has
historically been required when a corporation is selling all or substantially all of its assets. The
Delaware courts have used both “qualitative” and “quantitative” tests in interpreting the phrase
“substantially all,” as it is used in Section 271 of the Delaware General Corporation Law
(“DGCL”), which requires stockholder approval for a corporation to “sell, lease or exchange all
or substantially all of its property and assets.”192
189
190
191
192
TBCA art. 5.02 § A; LLC Act arts. 10.01, 10.06; TRLPA § 2.11; TRPA § 9.03; TBOC § 10.051.
TBCA art. 5.02 § A; LLC Act arts. 10.01, 10.06; TRLPA § 2.11; TRPA § 9.03; TBOC §§ 10.151–.153.
See TBCA arts. 5.09, 5.10; TBOC § 10.251. See also Byron F. Egan and Curtis W. Huff, Choice of State of
Incorporation—Texas versus Delaware: Is It Now Time To Rethink Traditional Notions?, 54 SMU L. REV.
249, 287–88 (2001); Byron F. Egan and Amanda M. French, 1987 Amendments to the Texas Business
Corporation Act and Other Texas Corporation Laws, 25 BULL. OF SECTION ON CORP., BANKING & BUS. L. 1,
11–12 (1987).
See Gimbel v. The Signal Cos, 316 A.2d 599 (Del. Ch. 1974) (holding that assets representing 41% of net
worth but only 15% of gross revenues were not to be “substantially all”); Katz v. Bregman, 431 A.2d 1274
(Del. Ch. 1981) (holding that 51% of total assets, generating approximately 45% of net sales, to be
“substantially all”); and Thorpe v. CERBCO, Inc., 676 A.2d 436 (Del. 1996) (holding that the sale of
subsidiary with 68% of assets, which was primary income generator, is “substantially all”; court noted that
seller would be left with only one operating subsidiary, which was marginally profitable); See also
Hollinger Inc. v. Hollinger Int’l, Inc., 858 A.2d 342 (Del. Ch. 2004), appeal denied, 871 A.2d 1128 (Del.
2004), in which (A) the sale of assets by a subsidiary with approval of its parent corporation (its
stockholder,) but not the stockholders of the parent, was alleged by the largest stockholder of the parent to
contravene DGCL § 271; (B) without reaching a conclusion, the Chancery Court commented in dicta that
[w]hen an asset sale by the wholly owned subsidiary is to be consummated by a contract
in which the parent entirely guarantees the performance of the selling subsidiary that is
disposing of all of its assets and in which the parent is liable for any breach of warranty
by the subsidiary, the direct act of the parent’s board can, without any appreciable
stretch, be viewed as selling assets of the parent itself;
and (C) examining the consolidated economics of the subsidiary level sale, the Chancery Court held (1) that
“substantially all” of the assets should be literally read, commenting that “[a] fair and succinct equivalent to
the term ‘substantially all’ would be “essentially everything,” notwithstanding past decisions that have
looked at sales of assets around the 50% level, (2) that the principal inquiry was whether the assets sold
were “quantitatively vital to the operations of” seller (the business sold represented 57.4% of parent’s
consolidated EBITDA, 49% of its revenues, 35.7% of the book value of its assets, and 57% of its asset
values based on bids for the two principal units of the parent), (3) that the parent had a remaining
substantial profitable business after the sale (the Chancery Court wrote: “if the portion of the business not
sold constitutes a substantial, viable, ongoing component of the corporation, the sale is not subject to
Section 271”), and (4) that the “qualitative” test of Gimbel focuses on “factors such as the cash-flow
generating value of assets” rather than subjective factors such as whether ownership of the business would
enable its managers to have dinner with the Queen. See Subcommittee on Recent Judicial Developments,
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Difficulties in determining when a shareholder vote is required in Delaware led Texas to
adopt a bright line test. TBCA arts. 5.09 and 5.10 provide, in essence, that shareholder approval
is required under Texas law only if it is contemplated that the corporation will cease to conduct
any business following the sale of assets.193 Under TBCA art. 5.10, a sale of all or substantially
all of a corporation’s property and assets must be approved by the shareholders, and shareholders
who vote against the sale can perfect appraisal rights. TBCA art. 5.09(A) provides an exception
to the shareholder approval requirement if the sale is “in the usual and regular course of the
business of the corporation,” and a 1987 amendment added section B to art. 5.09 providing that a
sale is
in the usual and regular course of business if, [after the sale,] the
corporation shall, directly or indirectly, either continue to engage
in one or more businesses or apply a portion of the consideration
received in connection with the transaction to the conduct of a
business in which it engages following the transaction.194
ABA Negotiated Acquisitions Committee, Annual Survey of Judicial Developments Pertaining to Mergers
and Acquisitions, 60 BUS. LAW. 843, 855–58 (2005); BALOTTI AND FINKELSTEIN, THE DELAWARE LAW OF
CORPORATIONS AND BUSINESS ORGANIZATIONS, section10.2 (3d ed. Supp. 2008). To address the
uncertainties raised by dicta in Vice Chancellor Strine’s opinion in Hollinger, DGCL section 271 was
amended effective August 1, 2005 to add a new subsection (c) which provides as follows:
(c) For purposes of this section only, the property and assets of the corporation
include the property and assets of any subsidiary of the corporation. As used in this
subsection, “subsidiary” means any entity wholly-owned and controlled, directly or
indirectly, by the corporation and includes, without limitation, corporations, partnerships,
limited partnerships, limited liability partnerships, limited liability companies, and/or
statutory trusts. Notwithstanding subsection (a) of this section, except to the extent the
certificate of incorporation otherwise provides, no resolution by stockholders or members
shall be required for a sale, lease or exchange of property and assets of the corporation to
a subsidiary.
193
194
This amendment answered certain questions raised by Hollinger, but raised or left unanswered other
questions (e.g., (i) whether subsection (c) applies in the case of a merger of a subsidiary with a third party
even though literally read DGCL § 271 does not apply to mergers, (ii) what happens if the subsidiary is less
than 100% owned, and (iii) what additional is meant by the requirement that the subsidiary be wholly
“controlled” as well as “wholly owned”).
See Egan and Huff, supra note 191, at 287–90.
In Rudisill v. Arnold White & Durkee, P.C., 148 S.W.3d 556 (Tex. App.—Houston [14th Dist.] 2004, no
pet.), the 1987 amendment to art. 5.09 was applied literally. The Rudisill case arose out of the combination
of Arnold White & Durkee, P.C. (“AWD”) with another law firm, Howrey & Simon (“HS”). The
combination agreement provided that all of AWD’s assets other than those specifically excluded, three
vacation condominiums, two insurance policies, and several auto leases, were to be transferred to HS in
exchange for a partnership interest in HS, which subsequently changed its name to Howrey Simon Arnold
& White, LLP (“HSAW”). In addition, AWD shareholders were eligible individually to become partners
in HSAW by signing its partnership agreement, which most of them did.
For business reasons, the AWD/HS combination was submitted to a vote of AWD’s shareholders. Three
AWD shareholders submitted written objections to the combination, voted against it, declined to sign the
HSAW partnership agreement, and then filed an action seeking a declaration of their entitlement to
dissenters’ rights or alternate relief. The court accepted AWD’s position that these shareholders were not
entitled to dissenters’ rights because the sale was in the “usual and regular course of business” as AWD
continued “to engage in one or more businesses” within the meaning of TBCA art. 5.09B, writing that
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TBOC sections 21.451 and 21.455 carry forward TBCA arts. 5.09 and 5.10.
The Texas partnership statutes do not contain any analogue to TBCA articles 5.09 and
5.10 and the parallel TBOC provisions applicable to corporations. They leave any such
requirement to the partnership agreement or another contract among the owners of the entity.195
The Texas LLC Statutes reach a similar result, but under the TBOC it would be necessary to
affirmatively provide that no owner vote is required to approve a sale of all or substantially all of
the assets of the LLC.196
An important reason for structuring an acquisition as an asset transaction is the desire on
the part of a buyer to limit its responsibility for liabilities of the seller, particularly unknown or
contingent liabilities. Unlike a stock purchase or statutory combination, where the acquired
corporation retains all of its liabilities and obligations, known and unknown, the buyer in an asset
purchase has an opportunity to determine which liabilities of the seller it will contractually
assume. In certain other jurisdictions, the purchase of an entire business, where the shareholders
of the seller become shareholders of the buyer, can cause a sale of assets to be treated as a
common law “de facto merger,” which would result in the buyer becoming responsible as a
matter of law for seller liabilities which buyer did not contractually assume.197
Texas has legislatively repealed the de facto merger doctrine in TBCA art. 5.10B, which
provides in relevant part that “[a] disposition of any, all, or substantially all, of the property and
assets of a corporation . . . (1) is not considered to be a merger or conversion pursuant to this Act
or otherwise; and (2) except as otherwise expressly provided by another statute, does not make
the acquiring corporation, foreign corporation, or other entity responsible or liable for any
liability or obligation of the selling corporation that the acquiring corporation, foreign
corporation, or other entity did not expressly assume.”198 TBOC section 10.254 carries forward
TBCA art. 5.10B and makes it applicable to all domestic entities.
195
196
197
198
“AWD remained in the legal services business, at least indirectly, in that (1) its shareholders and employees
continued to practice law under the auspices of HSAW, and (2) it held an ownership interest in HSAW,
which unquestionably continues directly in that business.” The court further held that AWD’s obtaining
shareholder approval when it was not required by TBCA art. 5.09 did not create appraisal rights, pointing
out that appraisal rights are available under the statute only “if special authorization of the shareholders is
required.” See Subcommittee on Recent Judicial Developments, ABA Negotiated Acquisitions
Committee, supra note 192, at 855–60.
See TBOC § 153.152.
TBOC § 1.002(32) defines “fundamental business transaction” to include a “sale of all or substantially all
of the entity’s assets” and TBOC § 101.356 requires a member vote to approve any fundamental business
transaction, although TBOC § 101.052 would allow the parties to include in the company agreement
provisions that trump this TBOC requirement.
See Knapp v. N. Am. Rockwell Corp., 506 F.2d 361 (3d Cir. 1974); Phila. Elec. Co. v. Hercules, Inc., 762
F.2d 303 (3d Cir. 1985); SmithKline Beecham Corp. v. Rohm & Haas Corp., 89 F.3d 154 (3d Cir. 1996);
Cargo Partner AG v. Albatrans Inc., 352 F.3d 41 (2d Cir. 2003).
In C.M. Asfahl Agency v. Tensor, Inc., 135 S.W.3d 768, 780–81 (Tex. App.—Houston [1st Dist.] 2004), a
Texas Court of Civil Appeals, quoting TBCA art. 5.10(B)(2) and citing two other Texas cases, wrote:
This transaction was an asset transfer, as opposed to a stock transfer, and thus governed
by Texas law authorizing a successor to acquire the assets of a corporation without
incurring any of the grantor corporation’s liabilities unless the successor expressly
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2.
Conversions
(a)
General
Texas law allows corporations, LLCs and partnerships to convert from one form of entity
into another without going through a transfer of assets or merger.199 A conversion is not a
combination of entities; rather, it is only a change in the statutory form and nature of an existing
entity. Additionally, a conversion involves only one entity and does not involve any change in
the ownership of that entity, although it may change the rights of the owners. The TBOC and the
older Texas entity statutes all have provisions relating to the mechanics of adopting a plan of
conversion, obtaining owner approval, filing with the Secretary of State, and protecting creditors.
Those Texas statutes and the federal income tax consequences of conversions are summarized
below.
(b)
Texas Statutes
Under the conversion provisions of Texas law,200 a Texas corporation may convert into
another corporation or other entity if (i) the conversion is approved by its shareholders in the
same manner as a merger in which the corporation is not the surviving entity would be approved;
(ii) the conversion is consistent with the laws under which the resulting entity is to be governed;
(iii) shareholders will have a comparable interest in the resulting entity unless a shareholder
exercises his statutory dissenter’s rights or otherwise agrees; (iv) no shareholder will become
personally liable for the obligations of the resulting entity without his consent; and (v) the
resulting entity is a new entity formed as a result of the conversion rather than an existing entity,
which would be a merger.201 Partnerships, limited partnerships, and LLCs are afforded
comparable rights.202
199
200
201
assumes those liabilities. [citations omitted] Even if the Agency’s sales and marketing
agreements with the Tensor parties purported to bind their ‘successors and assigns,’
therefore, the agreements could not contravene the protections that article 5.10(B)(2)
afforded Allied Signal in acquiring the assets of the Tensor parties unless Allied Signal
expressly agreed to be bound by Tensor parties’ agreements with the Agency.
See Egan & Huff, supra note 191, at 287–90.
TBCA Part Five; TBOC Chapter 10, Subchapter (C); cf. ABA Committee on Corporate Laws, Changes in
the Model Business Corporation Act Relating to Domestication and Conversion—Final Adoption, 58 BUS.
LAW 219 (2002).
TBCA arts. 5.17–.20; TBOC §§ 10.101–.151, 10.154–.203.
TBOC § 10.101. Under TBOC section 10.106, when a conversion takes effect upon the filing of a
certificate of conversion with the Secretary of State after following the above procedures:
(1)
the converting entity shall continue to exist, without interruption, but in the organizational form of
the converted entity rather than in its prior organizational form;
(2)
all rights, titles, and interests to all real estate and other property owned by the converting entity
shall continue to be owned by the converted entity in its new organizational form without
reversion or impairment, without further act or deed, or without any transfer or assignment having
occurred, but subject to any existing liens or other encumbrances thereon;
(3)
all liabilities and obligations of the converting entity shall continue to be liabilities and obligations
of the converted entity in its new organizational form without impairment or diminution by reason
of the conversion;
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(c)
Federal Income Tax Consequences
As in the case of organizational choice of entity determinations and business
combinations, a conversion transaction should not be undertaken without a thorough analysis of
the federal and state income tax consequences of the conversion. The following sections provide
a brief summary of some of the federal income tax consequences of certain conversion
transactions.203
(1)
Conversions of Entities Classified as Partnerships
There generally should be no federal income tax consequences arising from the
conversion of an entity classified as a domestic partnership for federal income tax purposes (e.g.,
general partnerships, LLPs, limited partnerships, and LLCs) into another entity classified as a
domestic partnership for federal income tax purposes, provided that the owners’ capital and
profit interests and shares of entity liabilities do not change as a result of the conversion, and the
entity’s business and assets remain substantially unchanged.204 These transactions are viewed as
202
203
204
(4)
all rights of creditors or other parties with respect to or against the prior interest holders or other
owners of the converting entity in their capacities as such in existence as of the effective time of
the conversion will continue in existence as to those liabilities and obligations and may be pursued
by such creditors and obligees as if the conversion had not occurred;
(5)
a proceeding pending by or against the converting entity or by or against any of its owners or
members in their capacities as such may be continued by or against the converted entity in its new
organizational form and by or against the prior owners or members without any need for
substitution of parties;
(6)
the ownership or membership interests in the converting entity that are to be converted into
ownership or membership interests in the converted entity as provided in the plan of conversion
shall be so converted, and the former holders of ownership or membership interests in the
converting entity shall be entitled only to the rights provided in the plan of conversion or rights of
dissent and appraisal under the TBOC;
(7)
if, after the effectiveness of the conversion, an owner or member of the converted entity would be
liable under applicable law, in such capacity, for the debts or obligations of the entity, such owner
or member shall be liable for the debts and obligations of the entity that existed before the
conversion takes effect only to the extent that such owner or member: (a) agreed in writing to be
liable for such debts or obligations, (b) was liable under applicable law, prior to the effectiveness
of the conversion, for such debts or obligations, or (c) by becoming an owner or member of the
converted entity becomes liable under applicable law for existing debts and obligations of the
converted entity; and
(8)
if the converted entity is one not governed by the TBOC, then it is considered (a) to have
appointed the Texas Secretary of State as its registered agent for purposes of enforcing any
obligations or dissenters’ rights and (b) to have agreed to promptly pay the dissenting members or
owners of the converting entity any amounts owed under the TBOC.
See also TBCA art. 5.20.
See TBOC § 10.101. The comparable provisions for such entities governed by pre-TBOC law are found for
LLCs at LLC Act sections 10.08–.11, for limited partnerships at TRLPA section 2.15, and for general
partnerships at TRPA sections 9.01, 9.05 and 9.06.
See Monte A. Jackel & Glen E. Dance, Selected Federal Income Tax Aspects of Changing the Tax Status of
Business Entities, 3 PLI/TAX STRATEGIES 255 (1997).
See e.g., Rev. Rul. 95-37, 1995-17 I.R.B. 10; Rev. Rul. 86-101, 1986-2 C.B. 94; Rev. Rul. 84-52, 1984-1 C.B.
157.
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tax-free contributions under Section 721 of the IRC that do not cause the existing entity to
terminate under Section 708, and do not cause the taxable year of the existing entity to close with
respect to any or all of the partners or members. A new taxpayer identification number is not
required. Careful attention should be paid when determining the partners’ or members’ correct
share of the entity’s liabilities before and after the conversion, because a decrease in a partner’s
or member’s share of those liabilities that exceeds the partner’s or member’s adjusted basis in its
interest will result in recognition of gain.
The conversion of an entity classified as a partnership to an entity that is ignored for
federal income tax purposes will occur if such entity only has a single member. For example, if
one member of a two member LLC purchases the other member’s interest, the partnership is
deemed to make a liquidating distribution of all of its assets to the members, with the purchasing
member treated as acquiring the assets distributed to the selling member. However, the selling
member, is treated as selling a partnership interest.205 Partnership liquidations generally do not
result in recognition of gain by the partners, except to the extent that the amount of cash
(marketable securities are in certain cases treated as cash) actually or constructively received by
a partner exceeds the partner’s adjusted basis in his partnership interest.206 Note that
distributions of property contributed to the partnership within seven years of the date of the
deemed distribution may result in gain recognition pursuant to I.R.C. §§ 704(c)(1)(B) and 737.207
Conversion of an entity classified as a partnership into a corporation will generally be
analyzed as a liquidating transaction with respect to the partnership and an incorporation
transaction with respect to the corporation, either of which can result in recognition of gain by
the owners of the converted entity.208 Nevertheless, with careful planning, most conversions of
this type can be accomplished without recognition of gain.209
(2)
Conversions of Entities Classified as Corporations
Conversion of an entity classified as a corporation into an entity classified as a
partnership or an entity ignored for federal income tax purposes will generally be treated as a
taxable liquidating transaction with respect to the corporation and, in the case of conversion to a
partnership entity, a contribution transaction with respect to the partnership entity.210 A
corporation cannot be converted into an entity classified as a partnership or sole proprietorship in
a tax-free transaction. In the case of a C-corporation, other than one that is owned 80% or more
by another corporation, the liquidation potentially may be subject to tax at both the corporate and
shareholder levels. The corporation will recognize gain or loss equal to the difference between
the fair market value of each tangible and intangible asset of the corporation and the
corporation’s adjusted basis in each respective asset.211 The shareholders will recognize gain or
205
206
207
208
209
210
211
Rev. Rul. 99-6, 1999-1 C.B. 432.
See I.R.C. § 731 (1997); I.R.C. § 736 (1993); I.R.C. § 751(b) (2004); Treas. Reg. § 301.7701-3(g) (2006).
See I.R.C. § 704(c)(1)(B) (2004); I.R.C. § 737 (1997).
See, e.g., I.R.C. § 751(b) (2004); I.R.C. § 351 (2005).
See Rev. Rul. 84-111, 1984-2 C.B. 88; Treas. Reg. § 301.7701-3(g) (2006).
Treas. Reg. § 301.7701-3(g)(1)(ii), (iii).
I.R.C. § 336 (1988).
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loss equal to the difference between the fair market value of the assets deemed distributed to
them and their adjusted basis in the corporation’s shares.212 Contrary to “common wisdom” that
an S-corporation is taxed like a partnership, the same taxable liquidation rules apply to an
S-corporation and its shareholders, except that the corporate level gain realized by the
S-corporation on the deemed liquidation generally flows through to the individual returns of the
shareholders, thereby increasing their adjusted bases in their stock and eliminating or decreasing
the amount of shareholder level gain.213 In order to comply with the single-class-of-stock
requirement, careful tax analysis should be undertaken when converting a corporation with an
otherwise valid pre-conversion S-corporation election into partnership form electing postconversion Check-the-Box treatment as a corporation.
(d)
Effect on State Licenses
The Texas Attorney General has issued an opinion to the effect that “[w]hen a
corporation converts to another type of business entity in accordance with the TBCA, as a
general rule a state license held by the converting corporation continues to be held by the new
business entity . . . subject to the particular statutory requirements or regulations of the specific
state entity that issued the license.”214
G.
Use of Equity Interests to Compensate Service Providers
A corporation may compensate service providers using employee stock ownership plans
(“ESOPs”), restricted stock, non-qualified stock options, and incentive stock options; however,
incentive stock options and ESOPs are not available in other forms of organization. The grant of
equity interests or options to acquire equity interests to service providers in an entity taxed as a
partnership creates a number of tax uncertainties.215
H.
Choice of Entity
To facilitate the entity choice analysis, the following information is provided below: (1) a
summary comparison of the respective business entities; (2) a Decision Matrix in Part VIII; (3)
an Entity Comparison Chart in Appendix A; and (4) a Basic Texas Business Entities and
Federal/State Taxation Alternatives Chart in Appendix B.
II.
CORPORATIONS
A.
General
The primary advantages of operating a business as a corporation are generally considered
to include:
212
213
214
215
I.R.C. § 331(a) (1982).
I.R.C. § 1371(a) (2007); see also I.R.C. § 1363(a) (2007); cf. I.R.C. § 1374 (1989) (imposing a tax on builtin gains).
Op. Tex. Att’y Gen. No. JC-0126 (1999).
See William H. Hornberger & James R. Griffin, Stock Options and Equity Compensation, Address at the
47th
Annual
Texas
CPA
Tax
Institute
(Nov.
14–16,
2000),
available
at
http://images.jw.com/site/jsp/publicationinfo.jsp?id=56.
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•
•
•
•
Limited liability of shareholders
Centralization of management
Flexibility in capital structure
Status as a separate legal entity
The primary disadvantages of operating a business as a corporation are generally
considered to be as follows:
•
•
•
Expense of formation and maintenance
Statutorily required formalities
Tax treatment—double taxation for the C-corporation and restrictions on the Scorporation; state franchise taxes
Prior to January 1, 2006, Texas business corporations were organized under, and many
are still governed by, the TBCA,216 which was amended in 1997 by S.B. 555,217 in 2003 by H.B.
1165, in 2005 by H.B. 1507 and in 2007 by H.B. 1737. However, corporations formed after
January 1, 2006 are organized under and governed by the TBOC. For entities formed before that
date, only the ones voluntarily opting into the TBOC, or converting to a Texas entity on or after
January 1, 2006, will be governed by the TBOC until January 1, 2010, at which time all Texas
corporations will be governed by the TBOC.218
The TBOC provides that the TBOC provisions applicable to corporations (TBOC titles 1
and 2) may be officially and collectively known as “Texas Corporation Law.”219 However,
because until 2010 some Texas for-profit corporations will be governed by the TBCA and others
by the TBOC, and because the substantive principles under both statutes are generally the same,
the term “Tex. Corp. Stats.” is used herein to refer to the TBOC and the TBCA, as supplemented
by the TMCLA, collectively, and the particular differences between the TBCA and the TBOC
are referenced as appropriate.
B.
Taxation
Federal taxation of a corporation in the United States depends on whether the corporation
is a regular C-corporation, or has instead qualified for and elected S-corporation tax status.
1.
Taxation of C-Corporations
C-corporations are separately taxable entities under the IRC. Thus, C-corporation
earnings are subject to double taxation—first at the corporate level and again at the shareholder
level upon distribution of dividends. Like the personal income tax, corporate tax rates vary
depending on the level of income generated. The marginal corporate tax rates, based on taxable
income for 2006 are generally as follows:
216
217
218
219
TBCA arts. 1.01 et. seq.
Tex. S.B. 555, 75th Leg., R.S. (1997).
All foreign entities which initially register to do business in Texas after January 1, 2006 are subject to the
TBOC regardless of when formed. TBOC § 402.001(a)(13).
TBOC § 1.008(b).
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Taxable Income
$0–50,000
$50,001–75,000
$75,000–100,000
$100,000–335,000
$335,000–10,000,000
$10,000,000–15,000,000
$15,000,000–18,333,333
> $18,333,333
Marginal Tax Rate
15%
25%
34%
39%
34%
35%
38%
35%
A C-corporation’s shareholders must pay individual income taxes on any corporate
profits that are distributed to them as dividends. A corporation may reduce its taxable income by
paying salaries to its officers, directors or employees, which may help to minimize the effects of
double taxation; however, unreasonable compensation may be recharacterized by the IRS as a
constructive dividend, which is not deductible by the corporation and is also taxed as income to
the officer, director or employee.220 There can also be corporate level taxes on excessive
accumulations of earnings.
Because a C-corporation is a separately taxable entity, there is no flow-through of
income, deductions (including intangible drilling costs and depletion allowances), NOLs, or
capital losses to a C-corporation’s shareholders; however, a C-corporation’s shareholders are not
subject to self-employment tax on distributions they receive. Additionally, a C-corporation can
carry forward any unused losses and credits. If a C-corporation distributes appreciated assets to
its shareholders, it will recognize a taxable gain. Furthermore, a C-corporation will generally
recognize gain or loss on its liquidation, except for certain liquidations into a parent
corporation,221 and a shareholder will recognize taxable gain or loss on his or her interest in the
corporation upon the corporation’s liquidation or the shareholder’s disposition thereof.
However, both S- and C-corporations may be parties to a tax-free reorganization in which neither
the corporation nor its shareholders are subject to taxation.
2.
Taxation of S-Corporations
(a)
Effect of S-Corporation Status
S-corporation status is achieved by an eligible C-corporation making an election to be so
treated. All shareholders, including their spouses if their stock is community property, must
consent to such election. The result of electing S-corporation status is that no corporate level tax
is imposed on the corporation’s income. Instead, corporate level income is treated as having
been received by the shareholders, whether or not such income was actually distributed, and is
taxed at the shareholder level. An S-corporation that was previously a C-corporation is subject
to a corporate level tax (i) if it realizes a gain on the disposition of assets that were appreciated
(i.e., the fair market value exceeded the tax basis) on the date the S election became effective and
220
221
See Pediatric Surgical Assocs., P.C. v. Comm’r of Internal Revenue, T.C.M. 2001-81 (2001) (disallowing
claimed deductions for salaries paid to shareholder surgeons because it found that the salaries exceeded
reasonable allowances for services actually rendered and were disguised nondeductible dividends).
See I.R.C. § 336 (1988); I.R.C. 337 (1988).
42
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the disposition occurs within 10 years of that date,222 and (ii) on its excess net passive income,
subject to certain limits and adjustments, if it has subchapter C earnings and profits and more
than 25% of its gross receipts for the year is passive investment income.223
A shareholder’s deduction for S-corporation losses is limited to the sum of the amount of
the shareholder’s adjusted basis in his stock and in the corporation’s indebtedness to him.224 To
the extent a loss is not allowed due to this limitation, the loss generally is carried forward to the
next year.225
(b)
Eligibility for S-Corporation Status
To be eligible for S-corporation status, a corporation must (i) be a domestic corporation
(i.e., organized under the laws of a state of the United States),226 (ii) have no more than 100
shareholders (for this purpose, stock owned by a husband and wife is treated as owned by one
shareholder and all family members can elect to be treated as one shareholder),227 (iii) have no
more than one class of stock,228 and (iv) have no shareholders other than individuals who are
residents or citizens of the United States and certain trusts, estates, or exempt organizations (e.g.,
qualified employee benefit plans and I.R.C. § 501(c)(3) organizations).229 S-corporations may
have a C-corporation as a subsidiary, even if the S-corporation owns 80% or more of the Ccorporation. Additionally, an S-corporation may now own a qualified subchapter S subsidiary
(“QSSS”). A QSSS includes any domestic corporation that qualifies as an S-corporation and is
owned 100% by an S-corporation that elects to treat its subsidiary as a QSSS.230 A QSSS is not
treated as a corporation separate from the parent S-corporation; and all of the assets, liabilities,
and items of income, deduction, and credit are treated as though they belong to the parent Scorporation. For purposes of the requirement that an S-corporation have only one class of stock,
indebtedness may be treated as a second class of stock unless it meets the requirements of the
safe harbor rule for “straight debt,” the definition of which was expanded under the Small
Business Job Protection Act of 1996. Certain options may also constitute a prohibited second
class of stock. In order for the election of S-corporation status to be effective, the election must
be made by all shareholders of the corporation.
(c)
222
223
224
225
226
227
228
229
230
Termination of S-Corporation Status
I.R.C. § 1374 (1989); Treas. Reg. § 1.1374-1 (2005).
I.R.C. § 1374 (1989).
I.R.C. § 1366(d)(1) (2007);I.R.C. § 1367(b)(2)(A) (2007).
I.R.C. § 1366(d)(2)(A) (2007).
I.R.C. § 1361(b)(1), (c).
I.R.C. § 1361(b)(1)(A) (2005) (as amended by The American Jobs Creation Act of 2004).
I.R.C. § 1361(b)(1)(D) (2005); see discussion supra Part I. General: E. Texas Entity Taxation—7.
Conversions (discussing the single class of stock requirement as applied to limited partnerships electing
corporation status under Check-the-Box Regulations).
I.R.C. § 1361(b)(1)(B)–(C), (c)(6) (2005).
Paul G. Klug & Jay Nathanson, Small Business Job Protection Act of 1996 Increases the Attractiveness of S
Corporations, 53 J. MO. B. 219, 221 (1997).
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Once an S-corporation election has been made, the election continues in effect until (i) it
is voluntarily terminated by holders of more than one-half of the outstanding shares, (ii) the
corporation ceases to meet the eligibility requirements specified above, or (iii) the corporation
has subchapter C earnings and profits at the close of three consecutive taxable years, and has
gross receipts for each of such taxable years more than 25% of which are passive investment
income.231
(d)
Liquidation or Transfer of Interest
An S-corporation and its shareholders are treated in a manner similar to the way a Ccorporation and its individual shareholders are treated when a shareholder disposes of its interest
or the S-corporation is liquidated, except no double tax in most cases, or is a party to a
nontaxable reorganization.232
3.
Contributions of Appreciated Property
Owners of an S- or a C-corporation will generally recognize a taxable gain on appreciated
property contributed to the corporation in exchange for shares in the corporation, unless the
owners who contribute property will control 80% of the voting power and 80% of the total shares
of the corporation immediately after the transfer.233
4.
Texas Entity Taxes
Effective for tax years beginning on or after January 1, 2007, the Margin Tax replaces the
Texas franchise tax and is applicable to all corporations.234 As discussed in more detail in Part
I(E)(3) above, the tax is generally 1% of a statutorily defined gross receipts calculation, less
either: (i) compensation, or (ii) cost of goods sold.235
5.
Self-Employment Tax
Shareholders of an S-corporation are generally not subject to self-employment tax on
their share of the net earnings of trade or business income of the S-corporation if reasonable
compensation is paid to the shareholders active in the business.236
C.
Owner Liability Issues
Limited liability is one of the most important advantages of doing business as a
corporation. In corporate law, it is fundamental that shareholders, officers, and directors are
231
232
233
234
235
236
I.R.C. § 1362(d)(1)–(3) (2005).
See BITTKER & EUSTICE, supra note 87, at § 6.04.
I.R.C. § 351(a) (2005); I.R.C. § 358(a) (2002); I.R.C. § 362(a) (2007); I.R.C. § 368(c) (1999).
See discussion supra Part I. General—E. Texas Entity Taxation—3. Margin Tax.
Tex. Tax Code Ann. § 171.001 (Vernon 2002).
Rev. Rul. 59-221, 1959-1 C.B. 225; see also Priv. Ltr. Rul. 87-16-060 (Jan. 21, 1987) (ruling that Scorporation shareholders do not conduct the corporation’s business); Burgess J. W. Raby & William L. Raby,
Attempting to Avoid FICA and Self-Employment Tax, 93 TAX NOTES 803, 803–06 (2001).
44
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ordinarily protected from personal liability arising from the activities of the corporation.237 This
insulation from personal liability is said to be the natural consequence of the incorporation
process, and is supported by the theory or “fiction” that incorporation results in the creation of an
“entity” separate and distinct from the individual shareholders.238 While this general rule of
nonliability is given great deference by the courts, there are circumstances under which personal
liability may be imposed on the shareholders, officers, or directors of a corporation.
Generally, shareholders of a corporation will not be personally liable for debts and
obligations of the corporation in excess of the shareholder’s investment in the corporation. In
exceptional situations, a court will “pierce the corporate veil” or “disregard the corporate entity”
to find a shareholder personally liable for the activities of the corporation. In Castleberry v.
Branscum,239 the Texas Supreme Court enumerated circumstances under which the corporate
entity will be disregarded, including, among others, (1) when the corporate fiction is used as a
means of perpetrating fraud, (2) where a corporation is organized and operated as a mere tool or
business conduit (the “alter ego”) of another corporation (or person), (3) where the corporate
fiction is resorted to as a means of evading an existing legal obligation, (4) where the corporate
fiction is used to circumvent a statute, and (5) where the corporate fiction is relied upon as a
protection of crime or to justify wrong. TBCA article 2.21 was subsequently amended to
overrule Castleberry and define the circumstances under which a court may pierce the corporate
veil in contract cases.240 Under TBCA article 2.21, as amended, as well as the parallel provision
in TBOC Section 21.223, no shareholder, or affiliate of the shareholder or the corporation, may
be held liable for (i) any contractual obligation of the corporation on the basis that the
shareholder or affiliate is or was the alter ego of the corporation or on the basis of actual or
constructive fraud, a sham to perpetuate a fraud or a similar theory, unless it is shown that the
shareholder used the corporation for the purpose of perpetrating, and did perpetrate, an actual
fraud, primarily for the personal benefit of the shareholder or affiliate, or (ii) any obligation,
237
238
239
240
Delaney v. Fid. Lease Ltd., 517 S.W.2d 420, 423 (Tex. Civ. App.—El Paso 1974), aff’d in part and rev’d in
part on other grounds, 526 S.W.2d 543 (Tex. 1975).
Id.; Sutton v. Reagan & Gee, 405 S.W.2d 828 (Tex. Civ. App.—San Antonio 1966, writ ref’d n.r.e.).
Castleberry v. Branscum, 721 S.W.2d 270, 272 (Tex. 1986).
Castleberry was cited by the Texas Supreme Court in In re Smith, 192 S.W.3d 564, 568–69 (Tex. 2006),
which held that the alter ego theory was relevant in a post-judgment proceeding for determining a
defendant’s net worth for the purposes of determining the amount of security required to suspend
enforcement of a judgment (under Texas law the security required may not exceed the lesser of 50% of the
judgment debtor’s net worth or $25 million):
Because “[a]lter ego applies when there is such unity between corporation and individual
that the separateness of the corporation has ceased,” Castleberry v. Branscum, 721
S.W.2d 270, 272 (Tex.1986), an alter ego finding is relevant to the determination of the
judgment debtor’s net worth. * * *
Although the trial court did not abuse its discretion by considering the alter ego theory,
that does not mean that the trial court’s alter ego finding may be used to hold R.A. Smith
& Company, Inc. or any other nonparty liable for the judgment. A judgment may not be
amended to include an alter ego that was not named in the suit. Matthews Const. Co.,
Inc. v. Rosen, 796 S.W.2d 692, 693 (Tex.1990). Therefore, an alter ego finding in a postjudgment net worth proceeding may not be used to enforce the judgment against the
unnamed alter ego or any other non-judgment debtor, but only to determine the judgment
debtor’s net worth for the purposes of Rule 24.
45
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whether contractual, tort or other, on the basis that the corporation failed to observe any
corporate formality (e.g., maintaining separate offices and employees, keeping separate books,
holding regular meetings of shareholders and board of directors, keeping written minutes of such
meetings, etc.).241
D.
Management
The corporation form of business entity allows for an efficient and flexible management
structure. The traditional management structure of a corporation is centralized.242 Shareholders
elect directors, who are given the power to manage the affairs of the corporation generally, as
well as to formulate policies and objectives.243 Shareholders retain the power to vote on certain
major matters.244 Directors appoint officers, who are delegated the authority to manage the
corporation’s day to day affairs and to implement the policies and objectives set by the directors.
241
242
243
244
TBCA art. 2.21 (emphasis added); TBOC § 21.223; S. Union Co. v. City of Edinburg, 2003 WL 22495756
(Tex. 2003) (repudiating the single business enterprise doctrine, and holding that “[s]ince 1993 . . . [S]ection
A of [A]rticle 2.21 is the exclusive means for imposing liability on a corporation for the obligations of
another corporation in which it holds shares” and that actual fraud is required to be plead and proved in a
veil piercing case based on a contract claim); See Egan & Huff, supra note 191, at 301–02; see also
Bromberg et al., Role of the Business-Updated, supra note 7, at 64, 67 and 72 (2005); Bromberg et al., Role of
the Business-Original, supra note 7, at 2, 19, 22; James G. Gaspard, III, A Texas Guide to Piercing and
Preserving the Corporate Veil, 31 BULL. OF BUS. L. SEC. OF THE ST. B. OF TEX. 24 (Sept. 1994). The later two
articles were written prior to, and thus do not reflect, the changes to TBCA article 2.21 effected in 1997.
Some courts, however, continue to ignore TBCA article 2.21, perhaps because the litigants fail to bring it to
the attention of the court, and cite Castleberry as authority. See, e.g., Cementos de Chihuahua, S.A. de C.V.
v. Intermodal Sales Corp., 162 S.W.3d 581, 586–87 (Tex. App.—El Paso 2005, no pet.).
Douglas K. Moll, Shareholder Oppression & Reasonable Expectations: Of Change, Gifts, and Inheritances
in Close Corporation Disputes, 86 MINN. L. REV. 717, 724 (2002).
Capital Bank v. Am. Eyewear, Inc., 597 S.W.2d 17, 20 (Tex. App.—Dallas 1980, no writ) (declaring that
“the authority to manage a corporation’s affairs is vested in its board of directors.”).
TBCA art. 2.28 and TBOC section 21.358 provide that the general requirement for a quorum of shareholders
at a meeting of shareholders will be the holders of a majority of the outstanding shares entitled to vote at the
meeting. This requirement may be increased or decreased to as few as one-third of the holders of the
outstanding shares if so provided in the articles of incorporation or certificate of formation. Once there is a
quorum of shareholders at a meeting of shareholders, there is a quorum for all matters to be acted upon at that
meeting. Electronic meetings of shareholders are permitted by TBCA art. 2.24 if authorized in the articles of
incorporation or bylaws. TBOC section 6.002 permits electronic meetings, subject to an entity’s governing
documents.
The vote required for approval of certain matters varies depending on the matter requiring action. The vote
required for the election of directors is a plurality of votes cast unless otherwise provided in the charter or
bylaws of the corporation. TBCA art. 2.28; TBOC § 21.359. The vote required for approval of fundamental
corporate transactions, such as charter amendments, mergers and dissolutions, is the holders of at least
two-thirds of the outstanding shares entitled to vote on the matter unless otherwise provided in the charter of
the corporation. TBCA arts. 4.02A(3), 5.03E, and 6.03A(3); TBOC § 21.364. The articles of incorporation
or certificate of formation may increase this voting requirement, or reduce it to not less than the holders of a
majority of the voting power entitled to vote on the matter. TBCA art. 2.28D; TBOC. § 21.365(a).
Unless otherwise provided in the corporation’s articles of incorporation, certificate of formation, or bylaws,
the general vote requirement for shareholder action on matters other than the election of directors and
extraordinary transactions is a majority of the votes cast “for,” “against” or “expressly abstaining” on the
matter. TBCA art. 2.28(B); TBOC § 21.363.
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Most corporate statutes, including the TBCA, the TBOC and the Delaware General
Corporation Law (the “DGCL”), also provide for “close corporations” which may be managed
by the shareholders directly.245 A Texas corporation elects “close corporation” status by
including a provision to such effect in its articles of incorporation or certificate of formation, and
may provide in such document or in a shareholder agreement, which can be similar to a
partnership agreement, that management will be by a board of directors or by the shareholders.246
Under the Tex. Corp. Stats., any Texas corporation, except a corporation whose shares are
publicly traded, may modify how the corporation is to be managed and operated, in much the
same way as a close corporation, by an agreement set forth in the articles of incorporation, the
certificate of formation, or the bylaws approved by all of the shareholders, or in a written
agreement signed by all of the shareholders.247 Thus, the management structure of corporations
In corporations formed prior to September 1, 2003, unless expressly prohibited by the articles of
incorporation, shareholders have the right to cumulate their votes in the election of directors if they notify the
corporation at least one day before the meeting of their intent to do so; for corporations formed on or after
September 1, 2003, shareholders do not have the right to cumulative voting unless the articles of incorporation
or certificate of formation expressly grants that right. TBCA art. 2.29D; TBOC §§ 21.360, 21.362.
Each outstanding share is entitled to one vote unless otherwise provided in the corporation’s articles of
incorporation or certificate of formation. TBCA art. 2.29(A)(1); TBOC § 21.366(a). Furthermore, unless
divided into one or more series, shares of the same class are required to be identical. TBCA art. 2.12(A);
TBOC § 21.152(c). Limitations on the voting rights of holders of the same class or series of shares are
permitted, depending on the characteristics of the shares. TBCA art. 2.29(A)(2); TBOC § 21.153.
The voting of shares by proxy is permitted. TBCA art. 2.29; TBOC § 21.367(a). However, no proxy will be
valid eleven months after execution unless otherwise provided in the proxy. TBOC § 21.368. Proxies may be
made irrevocable if coupled with an interest and may be in the form of an electronic transmission. TBCA art.
2.29(C); TBOC §§ 21.367(b), 21.369(b).
245
246
247
See J. Leon Lebowitz, Texas Close Corporation Law, 44 TEX. B.J. 51 (1981); Robert W. Hamilton,
Corporations and Partnerships, 36 SW. L.J. 227, 228–34 (1982).
TBCA arts. 12.11, 12.13, 12.31; TBOC §§ 3.008, 21.703, 21.713.
TBCA art. 2.30-1 and TBOC section 21.101 in effect extend close corporation flexibility to all corporations
that are not publicly traded by authorizing shareholders’ agreements that modify and override the mandatory
provisions of the TBCA or the TBOC relating to operations and corporate governance. The agreement must
be set forth in either (i) the articles of incorporation or bylaws and approved by all shareholders or (ii) in an
agreement signed by all shareholders and made known to the corporation. TBCA art. 2.30-1(B)(1); TBOC §
21.101(b). The agreement is not required to be filed with the Secretary of State unless it is part of the articles
of incorporation. TBCA arts. 2.30-1(B), 3.03; TBOC §§ 21.101(b), 4.002. An agreement so adopted may:
(1)
restrict the discretion or powers of the board of directors;
(2)
eliminate the board of directors and permit management of the business and affairs of the corporation
by its shareholders, or in whole or in part by one or more of its shareholders, or by one or more
persons not shareholders;
(3)
establish the natural persons who shall be the directors or officers of the corporation, their term of
office or manner of selection or removal, or terms or conditions of employment of any director,
officer, or other employee of the corporation, regardless of the length of employment;
(4)
govern the authorization or making of distributions, whether in proportion to ownership of shares,
subject to the limitations in TBCA Article 2.38 (or TBOC section 21.303, as the case may be), or
determine the manner in which profits and losses shall be apportioned;
(5)
govern, in general or in regard to specific matters, the exercise or division of voting power by and
between the shareholders, directors (if any), or other persons or by or among any of them, including
use of disproportionate voting rights or director proxies;
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is generally flexible enough to allow both centralized management and decentralized
management, depending on the needs of the corporation’s owners.
E.
Fiduciary Duties
1.
General
Directors of a corporation owe fiduciary duties of care, loyalty, and obedience to the
corporation.248 The duty of care requires directors to exercise the degree of care that an
(6)
establish the terms and conditions of any agreement for the transfer or use of property or the
provision of services between the corporation and any shareholder, director, officer or employee of
the corporation, or other person or among any of them;
(7)
authorize arbitration or grant authority to any shareholder or other person as to any issue about which
there is a deadlock among the directors, shareholders or other person or persons empowered to
manage the corporation to resolve that issue;
(8)
require dissolution of the corporation at the request of one or more of the shareholders or upon the
occurrence of a specified event or contingency in which case the dissolution of the corporation shall
proceed as if all the shareholders had consented in writing to dissolution of the corporation as
provided in TBCA Article 6.02 or TBOC sections 21.501–.504; or
(9)
otherwise govern the exercise of corporate powers or the management of the business and affairs of
the corporation or the relationship among the shareholders, the directors and the corporation, or
among any of them, as if the corporation were a partnership or in a manner that would otherwise be
appropriate only among partners, and is not contrary to public policy.
TBCA art. 2.30-1(A); TBOC § 21.101(a). The existence of an Article 2.30-1 or TBOC section 21.101
agreement must be conspicuously noted on the certificates representing the shares or on the information
statement required for uncertificated shares. TBCA art. 2.30-1(C); TBOC § 21.103(a), (b). A purchaser who
acquires shares of a corporation without actual or deemed knowledge of the agreement will have a right of
rescission until the earlier of (i) 90 days after obtaining such knowledge or (ii) two years after the purchase of
the shares. TBCA art. 2.30-1(D); TBOC § 21.105. An agreement permitted under Article 2.30-1 or TBOC §
21.101 will cease to be effective when shares of the corporation become listed on a national securities
exchange, quoted on an interdealer quotation system of a national securities association or regularly traded in
a market maintained by one or more members of a national or affiliated securities association. TBCA art.
2.30-1(E); TBOC § 21.109.
An Article 2.30-1 or Section 21.101 agreement that limits the discretion or powers of the board of directors or
supplants the board of directors will relieve the directors of, and impose upon the person or persons in whom
such discretion or powers or management of the business and affairs of the corporation are vested, liability for
action or omissions imposed by the TBCA, the TBOC, or other law on directors to the extent that the
discretion or powers of the directors are limited or supplanted by the agreement.
248
Article 2.30-1(G) and TBOC Section 21.107 provide that the existence or performance of an Article 2.30-1 or
Section 21.101 agreement will not be grounds for imposing personal liability on any shareholder for the acts
or obligations of the corporation by disregarding the separate entity of the corporation or otherwise, even if the
agreement or its performance (i) treats the corporation as if it were a partnership or in a manner that otherwise
is appropriate only among partners, (ii) results in the corporation being considered a partnership for purposes
of taxation, or (iii) results in failure to observe the corporate formalities otherwise applicable to the matters
governed by the agreement. Thus, Article 2.30-1 and TBOC Section 21.107 provide protection beyond
Article 2.21 and TBOC Section 21.223 on shareholder liability.
Gearhart Indus., Inc. v. Smith Intern. Inc., 741 F.2d 707 (5th Cir. 1984); see Byron F. Egan, Governance
Principles
for
Board
Committee
Members,
available
at
http://www.jw.com/site/jsp/publicationinfo.jsp?id=717; Egan & Huff, supra note 191, at 259–70.
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ordinarily prudent person would exercise under similar circumstances.249 The duty of loyalty
dictates that a director must act in good faith and must not allow personal business interests to
prevail over the interests of the corporation.250 In general, a director will not be permitted to
derive a personal profit or advantage at the expense of the corporation and must act solely with
an eye to the best interest of the corporation, unhampered by any pecuniary interest of his
own.251 Generally the duty of loyalty prohibits a director from usurping business opportunities
that otherwise might be pursued by the corporation;252 however, Texas law permits a corporation
to renounce any interest in business opportunities presented to the corporation or one or more of
its officers, directors or shareholders in its certificate of formation or by action of its board of
directors.253 The duty of obedience requires directors to obey the law and the articles of
incorporation.254 Controlling shareholders owe a fiduciary duty to the minority shareholders to
deal fairly with them.255
2.
Business Judgment Rule
The business judgment rule provides a degree of protection to decisions made by
corporate directors. Under the business judgment rule, directors are presumed to have satisfied
their fiduciary duties in making a business decision.256 Under Delaware law, for the business
judgment rule to apply, a decision must be made by disinterested directors who act in good faith
after reasonable investigation and who honestly and reasonably believe that the decision will
249
250
251
252
253
254
255
256
Gearhart, 741 F.2d at 720.
Id. at 719 (holding that the good faith of a director will be determined by whether the director acted with an
intent to confer a benefit to the corporation); see Int’l Bankers Life Ins. Co. v. Holloway, 368 S.W.2d 567,
578 (Tex. 1963) (holding that whether there exists a personal interest by the director will be a question of
fact; cf. Lyman Johnson, After Enron: Remembering Loyalty Discourse in Corporate Law, 28 DEL. J. CORP.
L. 27 (2003).
See A. Copeland Enters., Inc. v. Guste, 706 F. Supp. 1283, 1291 (W.D. Tex. 1989); Milam v. Cooper Co., 258
S.W.2d 953, 956 (Tex. Civ. App.—Waco 1953, writ ref’d n.r.e.); see also TBCA art. 2.35-1(A) and TBOC §
21.418 (validating director transactions if (1) disinterested directors, after disclosure, approve the transaction;
(2) shareholders of the corporation, after disclosure, approve the transaction; or (3) the transaction is otherwise
fair); cf. In re Mi-Lor Corp., 348 F.3d 294, 303 (1st Cir. 2003) (holding that a duty of full disclosure is
imposed on directors in cases of self dealing). See generally John T. Kendrick, Jr., The Interested Director in
Texas, 21 SW. L.J. 794 (1967).
The basic framework of the corporate opportunity doctrine was laid down by the Delaware Supreme Court
in Guth v. Loft, Inc., as follows:
[I]f there is presented to a corporate officer or director a business opportunity which the
corporation is financially able to undertake, is, from its nature, in the line of the
corporation’s business and is of practical advantage to it, is one in which the corporation
has an interest or a reasonable expectancy, and, by embracing the opportunity, the selfinterest of the officer or director will be brought into conflict with that of his corporation,
the law will not permit him to seize the opportunity for himself.
Guth v. Loft, Inc., 5 A.2d 503, 511 (Del. 1939); see also Kohls v. Duthie, 791 A.2d 772, 783–85 (Del. Ch.
2000).
TBCA art. 2.02(20), TBOC § 2.101(21).
Gearhart, 741 F.2d at 719.
See In re Pure Res., Inc., 808 A.2d 421, 433 (Del. Ch. 2002).
See AC Acquisitions Corp. v. Anderson, Clayton & Co., 519 A.2d 103, 111 (Del. Ch. 1986).
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reasonably benefit the corporation.257 Under Texas law, the business judgment rule appears to be
more favorable to directors than under Delaware law, because directors’ actions are presumed to
be valid if no conflict of interest exists, and the action is not ultra vires or tainted by fraud.258
3.
Overcoming Business Judgment Rule
The business judgment rule is only a presumption that protects directors from liability
arising out of business decisions made for the corporation. If the presumption created by the
business judgment rule is overcome or shown not to apply, then the burden shifts to the director
to justify the fairness of the transaction to the corporation.259
4.
Limitation of Director Liability
Texas Miscellaneous Corporation Laws Act (the “TMCLA”) article 1302-7.06 provides
that a Texas corporate entity governed in whole or in part by the TBCA, the Texas Non-Profit
Corporation Act, the Finance Code, or the TMCLA may provide in its articles of incorporation,
as initially filed or by amendment, that a director shall not be liable to the corporation or its
shareholders for an act in the director’s capacity as a director, except to the extent that the
director is found liable for (i) a breach of the duty of loyalty to the corporation or its
shareholders, (ii) an act or omission not in good faith that constitutes a breach of duty to the
corporation, or that involves intentional misconduct, or a knowing violation of law, (iii) a
transaction from which the director received an improper personal benefit, or (iv) an act or
omission for which the liability of the director is expressly provided by statute.260 Sections
7.001(b) and (c) of the TBOC allow for similar such limitation of director liability for corporate
entities governed by the TBOC. Neither the TMCLA nor the TBOC authorizes the limitation of
liability of an officer or a director acting in the capacity of an officer.261
F.
257
258
259
260
261
Ability to Raise Capital
Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985); Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946,
958 (Del. 1985). See Byron F. Egan, Fiduciary Duty Update: Delaware and Texas, available at
http://www.jw.com/site/jsp/publicationinfo.jsp?id=855; Egan & Huff, supra note 191, at 263–70.
See Gearhart, 741 F.2d at 719–21; Egan & Huff, supra note 191, at 260–63.
Gearhart, 741 F.2d at 720.
See Egan & Huff, supra note 191, at 272–73; Egan & French, supra note 191, at 16–21.
See TBOC § 7.001(b)
The certificate of formation . . . may provide that a governing person of the organization
is not liable, or is liable only to the extent provided by the certificate of formation or
similar instrument, to the organization or its owners or members for monetary damages
for an act or omission by the person in the person’s capacity as a governing person.
(emphasis added)). See also TMCLA § 1302-7.06B. A corporate officer is an agent of the corporation.
Joseph Greenspon’s Sons Iron & Steel Co. v. Pecos Valley Gas Co., 156 A. 350 (Del. Ch. 193l); Hollaway
v. Skinner, 898 S.W.2d 793, 795 (Tex. 1995). If an officer commits a tort while acting for the corporation,
under the law of agency, the officer is liable personally for his actions. See Dana M. Muir & Cindy A.
Schipani, The Intersection of State Corporation Law and Employee Compensation Programs: Is it
Curtains for Veil Piercing? 1996 U. ILL. L. REV. 1059, 1078–79 (1996); cf. Centurion Planning Corp.. v.
Seabrook Venture II, 176 S.W.3d 498, 509 (Tex. App.—Houston [1st Dist.] 2004). The corporation may
also be liable under respondeat superior.
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The corporation provides as much financing flexibility as any type of business entity.
Corporations are given the authority in their statutes and governing documents to use any
number of various devices to raise capital.262 Different classes and series of common stock and
preferred stock may be utilized to accommodate the desires of various types of investors.263
Equity can be raised at the base level by common stock as well as at levels ranking above the
common stock by preferred stocks.264 Equity can be leveraged through many types of
borrowings and financing devices, including stock options, warrants, and other forms of
securities. In addition, convertible debt interests may be utilized. The different levels of a
capital structure may include a differentiation in the voting rights assigned to equity holders,
which may even be distributed differently among classes of common stock or even denied as to
specified classes of common stock.
G.
Transferability of Ownership Interests
The ownership interests of shareholders in a corporation are freely transferable, subject to
the following restrictions discussed below:
1.
Restrictions on Transfer of Shares
Shareholders of a closely held corporation often desire to prohibit the transfer of shares to
persons who are not family members or are not employees of the corporation. To be
enforceable, these restrictions on transfer must be reasonable under state law. In any event, an
absolute restriction on transfer would be unreasonable and therefore void.265 The Tex. Corp.
Stats. provide that, among other restrictions, rights of first refusal and limitations on transfer
necessary to maintain S-corporation status or other tax advantages are reasonable restrictions on
transfer.266 They also specify certain procedures that must be followed to assure the
enforceability of the share transfer restrictions, such as the placement of a restrictive legend on
stock certificates and the maintenance of a copy of the document containing the transfer
restrictions at the corporation’s principal place of business or registered office.267 Because
shares in a closely held business typically lack an established trading market, those shares may
be nontransferable as a practical matter. If the owners of the business enterprise desire to
conduct an initial public offering for its shares, the corporate form of entity is the best option
except in certain limited circumstances.
2.
Securities Law Restrictions
Shares in a corporation are generally considered “securities” within the meaning of state
and federal securities laws. Transfers of shares may be required to be registered under such laws
absent an applicable exemption from registration.
262
263
264
265
266
267
ROBERT W. HAMILTON, CORPORATIONS 356 (7th ed. 2001).
See id. at 357–59.
See id. at 357–59.
See TBCA art. 2.22(C); see also TBOC § 21.213.
TBCA art. 2.22(D), (H); TBOC § 21.211.
TBCA art. 2.22(B), (C); TBOC §§ 21.210, 21.213.
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H.
Continuity of Life
Corporations frequently have perpetual existence, either by default under the TBOC or by
a provision in a corporation’s articles of incorporation under older Texas law.268 Because a
corporation is treated as a separate entity with continuity of life, events such as death or
bankruptcy of an owner have no effect on the legal structure of a corporation—at least absent a
specific shareholder agreement attaching consequences and procedures for certain events. Even
in bankruptcy, a shareholder continues to be a shareholder of the bankrupt entity. Shares can be
passed down to heirs. In contrast, under some existing non-Texas partnership laws, particularly
less modern ones, a partnership is not an entity separate from its partners, and a deceased
partner’s estate may have to be probated in each state where the partnership owns property.
Expenses and the hassle of multiple probate proceedings are avoided in a corporation, because
corporate shares are personal property subject to probate only in the deceased shareholder’s state
of domicile.
Under the pre-TBOC business entity rules, with respect to other types of entities, the
problems associated with a finite lifetime or unanticipated dissolution could be solved in many
cases in the drafting of the entity’s constituent documents. However, under the TBOC, all
domestic entities exist perpetually unless otherwise provided in its governing documents.269
Thus, the perpetual existence of a corporation is not an advantage to be given much weight in
determining the type of business entity to utilize, particularly because the TBOC governs all
newly formed entities.
I.
Formation
The formation of a corporation requires certain legal formalities and the preparation of
certain documents. Under the TBCA, articles of incorporation had to be prepared and filed with
the Secretary of State, along with the payment of a $300 filing fee.270 Under the TBOC, a
certificate of formation is the proper filing document.271 The articles of incorporation or
certificate of formation (either of them being hereinafter referred to as the “corporation’s
governing document”) establishes the initial board of directors and capital structure of the
corporation. After the Secretary of State officially acknowledges the filing of the corporation’s
governing document,272 there should be an organizational meeting of the initial board of directors
named in the corporation’s governing document, at the call of a majority of the directors, for the
purposes of adopting bylaws, electing officers, and transacting such other business as may come
before the meeting.273 The bylaws may contain any provisions for the regulation and
management of the affairs of the corporation not inconsistent with law or the corporation’s
268
269
270
271
272
273
TBOC § 3.003; TBCA art. 3.02(A) provides that the articles of incorporation shall set forth: “(2) The
period of duration, which may be perpetual.”
TBOC § 3.003.
TBCA arts. 3.02–.03.
TBOC §§ 3.001, 4.001. The filing fee for a for-profit corporation remains $300 under the Code. TBOC §
4.152(1).
TBOC § 4.002. Under pre-TBOC law, the Secretary of State would issue a Certificate of Incorporation
once a corporation properly filed its Articles of Incorporation.
TBCA art. 3.06; TBOC § 21.059.
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governing document.274 Although the initial bylaws of a corporation are ordinarily in writing
and adopted by the directors at the organization meeting of the board, the shareholders may
amend, repeal or adopt the bylaws, unless the corporation’s governing document or a bylaw
adopted by the shareholders provides otherwise.275 In the absence of a contrary provision in the
corporation’s governing document, the TBCA or the TBOC, bylaws may be adopted or amended
either orally or by acts evidenced by a uniform course of proceeding or usage and
acquiescence.276
J.
Operations in Other Jurisdictions
When a corporation does business outside of its state of incorporation, it may be required
to qualify to do business as a foreign corporation in the other states in which it does business
under statutory provisions comparable to TBCA Part Eight and TBOC Chapter 9 and subject to
taxation by those states. Over the years, there has evolved a substantial body of law for
analyzing these questions.277
K.
Business Combinations; Conversions
The Tex. Corp. Stats. now allow corporations, LLCs, and partnerships to merge with each
other (e.g., a limited partnership can merge into a corporation) and to convert from one form of
entity to another without going through a merger or transfer of assets.278 Both the TBOC and the
older entity statutes each have provisions relating to the mechanics of the adoption of a plan of
merger or conversion, owner approval, filings with the Secretary of State, and the protection of
creditors.
Under the conversion provisions of the Tex. Corp. Stats.,279 a Texas corporation may
convert into another corporation or other entity if (a) the conversion is approved by its
shareholders in the same manner as a merger where the corporation is not the surviving entity,
(b) the conversion is consistent with the laws under which the resulting entity is to be governed,
(c) shareholders will have a comparable interest in the resulting entity, unless the shareholder
exercises his dissenters’ rights under the Tex. Corp. Stats. or he otherwise agrees, (d) no
shareholder will become personally liable for the obligations of the resulting entity without his
consent, and (e) the resulting entity is a new entity formed as a result of the conversion rather
than an existing entity, which would be a merger. The Texas Corporate Statutes require
shareholder approval of the sale of all or substantially all of the assets of the corporation in
certain circumstances.280
274
275
276
277
278
279
280
TBCA art. 2.33A; TBOC § 21.057.
TBCA art. 2.23; TBOC § 21.058.
Keating v. K-C-K Corp., 383 S.W.2d 69 (Tex. Civ. App.—Houston 1964, no writ).
See CT CORPORATION, WHAT CONSTITUTES DOING BUSINESS (2008).
See TBCA Part Five; TBOC Chapter 10.
TBCA arts. 5.17–.20. Comparable provisions are found for LLCs at LLC Act §§ 10.08–.11, for limited
partnerships at TRLPA § 2.15, and for general partnerships at TRPA §§ 9.01, 9.05–.06. The TBOC contains
substantially similar provisions, all consolidated in Chapter 10, Subchapter C.
See supra notes 190–91 and accompanying text.
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L.
Anti-Takeover
TBCA Part Thirteen and TBOC Chapter 21, Subchapter M deal with business
combinations involving public companies where there is a change of control after which there
are minority shareholders by imposing a special voting requirement for business combinations
and other transactions involving a new controlling shareholder.281 These anti-takeover
provisions (i) apply only to an “issuing public corporation,”282 and (ii) prohibit a “business
combination,”283 which includes a merger, share exchange, sale of assets, reclassification,
conversion, or other transaction between the issuing public corporation and any “affiliated
shareholder”284 for three years after the affiliated shareholder became such, unless (iii) the
“business combination” is approved by the holders of not less than two-thirds of the voting
shares not beneficially owned by the affiliated shareholder at a meeting of shareholders held not
less than six months after the affiliated shareholder became such or, prior to the affiliated
shareholder becoming such, the board of directors approved either the business combination or
the affiliated shareholder’s acquisition of the shares that made him an affiliated shareholder.285
Tex. Corp. Stats. also confirm that a director, in discharging his duties, may consider the longterm, as well as the short-term, interests of the corporation and its shareholders.286
III.
GENERAL PARTNERSHIP
A.
General
Texas law will only recognize an association or organization as being a “partnership” if it
was created under (1) the TBOC, (2) the TRPA, (3) the older Texas Uniform Partnership Act
(“TUPA”),287 (4) the Texas Revised Limited Partnership Act (“TRLPA”)288 or (5) under a statute
of another jurisdiction which is comparable to any of the Texas statutes referred to in (1), (2),
281
282
283
284
285
286
287
288
TBCA arts. 13.01–.08; TBOC §§ 21.601–.610. State corporation statutes intended to restrain some of the
abuses associated with hostile takeovers were validated by the United States Supreme Court in CTS Corp. v.
Dynamics Corp. of Am., 481 U.S. 69 (1987). See Amanda Acquisition Corp. v. Universal Foods Corp., 877
F.2d 496, 505–09 (7th Cir. 1989), cert. denied, 493 U.S. 955 (1989) (upholding Wisconsin’s 3-year
moratorium statute); Byron F. Egan & Bradley L. Whitlock, State Shareholder Protection Statutes, Address at
the University of Texas 11th Annual Conference on Securities Regulation and Business Law Problems (Mar.
10, 1989).
“Issuing public corporation” is defined as a Texas corporation that has 100 or more shareholders of record,
has a class of voting shares registered under the Securities Exchange Act of 1934, or has a class of voting
shares qualified for trading on a national market system. TBCA arts. 13.02(A)(6), 13.03; TBOC §§
21.601(1), 21.606. These TBCA and TBOC provisions do not apply to corporations that are organized under
the laws of another state, but that have a substantial nexus to Texas, because such a “foreign application”
provision might jeopardize the constitutionality thereof. See, e.g., Tyson Foods, Inc. v. McReynolds, 700 F.
Supp. 906, 910–14 (M.D. Tenn. 1988); TLX Acquisition Corp. v. Telex Corp., 679 F. Supp. 1022, 1029–30
(W.D. Okla. 1987).
TBCA art. 13.02(A)(4); TBOC § 21.604.
“Affiliated shareholder” is defined as a shareholder beneficially owning 20% or more of the corporation’s
voting shares and certain of its related persons. TBCA Art. 13.02(A)(2); TBOC § 21.602.
TBCA art. 13.03 is based on DGCL § 203. See also TBOC § 21.606.
TBCA art. 13.06; TBOC § 21.401(b).
See statutes cites supra note 1.
TEX. REV. CIV. STAT. ANN. art. 6132a-1 (Vernon Supp. 2008).
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(3), or (4) above.289 If an association is created under a law other than those listed, then it is not
a partnership. A “partnership” is defined as an association of two or more persons to carry on a
business for profit, whether they intend to create a partnership and whether they call their
association a partnership, a joint venture or other name.290 The definition of a partnership is
crucial in litigation in which a person is arguing that he is not a partner, and that the partnership
disadvantages (e.g., individual, and joint and several liability of the obligations of the
partnership) should not be imposed upon him.
The TBOC governs all Texas general partnerships formed on or after January 1, 2006,291
as well as those formed before that date which voluntarily opt in to TBOC governance.292
Within the TBOC, Chapter 152 is specifically applicable to general partnerships, though many of
the general provisions in Title 1 and Title 4, Chapters 151 and 154, will also apply. The TBOC
provides that such provisions may be collectively known as “Texas General Partnership Law.”293
Until January 1, 2010, at which time all partnerships will be governed by the TBOC,294 all other
Texas general partnerships will be governed by the TRPA.295 Because until 2010 some general
partnerships will be governed by the TRPA and others by the TBOC, and because the substantive
principles under both statutes are generally the same, the term “Tex. GP Stats.” is used herein to
refer to the TBOC and the TRPA collectively, and the particular differences between the TRPA
and the TBOC are referenced as appropriate.
1.
Definition of “Person”
Any person may be a partner unless the person lacks capacity apart from the Tex. GP
Stats. Under TRPA, a “person” is defined to include “individual[s], corporation[s], business
trust[s], estate[s], trust[s], custodian[s], trustee[s], executor[s], administrator[s], nominee[s],
partnership[s of any sort], association[s], limited liability compan[ies], government[s],
governmental subdivision[s], governmental agenc[ies, etc.] . . . and any other legal or
commercial entity.”296 The definition of “person” under the new TBOC comes from the
Government Code,297 which provides that “‘[p]erson’ includes corporation, organization,
government or governmental subdivision or agency, business trust, estate, trust, partnership,
association, and any other legal entity.”298
2.
289
290
291
292
293
294
295
296
297
298
Factors Indicating Partnership
TRPA § 2.02; TBOC § 152.051(c).
TRLPA § 6(a)(1); TRPA § 2.02(a); TBOC § 152.051(b).
TBOC § 402.001.
TBOC § 402.003.
TBOC § 1.008(f).
TBOC § 402.005.
TRPA § 11.03(c). Prior to January 1, 1999, some entities were still governed by the Texas Uniform
Partnership Act. See TRPA § 11.03(a); Steven M. Cooper, The Texas Revised Partnership Act and the Texas
Uniform Partnership Act: Some Significant Differences, 57 TEX. B. J. 828 ( 1994).
TRPA § 1.01(14).
See TEX. GOV’T CODE ANN. § 311.002 (Vernon 2005) (regarding application of the Government Code to
construction of other Texas laws).
TEX. GOV’T CODE ANN. § 311.005.
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Under the Tex. GP Stats., the following factors indicate that persons have created a
partnership:299
•
Receipt or right to receive a share of profits;
•
Expression of an intent to be partners;
•
Participation or right to participate in control of the business;
•
Sharing or agreeing to share losses or liabilities; or
•
Contributing or agreeing to contribute money or property to the business.
3.
Factors Not Indicative of Partnership
Conversely, under Tex. GP Stats., the following circumstances do not individually
indicate that a person is a partner in a business:300
299
300
301
•
The right to receive or share in profits as (a) debt repayment, (b) wages or
compensation as an employee or independent contractor, (c) payment of rent, (d)
payment to a former partner, surviving spouse or representative of a deceased or
disabled partner, (e) a transferee of a partnership interest, (f) payment of interest,
or (g) payment of the consideration for the sale of a business;
•
Co-ownership of property whether in the form of joint tenancy, tenancy in
common, tenancy by the entireties, joint property, community property, or part
ownership, whether combined with sharing of profits from the property;
•
Sharing or having the right to share gross revenues regardless of whether the
persons sharing gross revenues have a common or joint interest in the property
from which they are derived; or
•
Ownership of mineral property under a joint operating agreement.301
TRPA § 2.03(a); TBOC § 152.052(a).
TRPA § 2.03(b); TBOC § 152.052(b).
The statement in TRPA section 2.03(b)(4) and TBOC section 152.052(b)(4) that “ownership of mineral
property under a joint operating agreement” is not a circumstance evidencing a partnership among the coowners is included to negate the possibility that a joint operating arrangement constitutes a “mining
partnership” and to give effect to the typical operating agreement provision stating that the parties do not
intend to create, and are not creating, a mining or other partnership. The law of mining partnerships is ably
summarized in Cullen M. Godfrey, Mining Partnerships: Liability Based on Joint Ownership and Operations
in Texas, XXXVII LANDMAN 35–36 (1993), which states:
The mining partnership exists by operation of law and need not be expressly
intended or adopted. Interests in mining partnerships may be freely transferred without the
consent of the other mining partners and neither the transfer of an interest nor the death of a
partner will serve to terminate the mining partnership. Thus, drilling operations need not be
interrupted or postponed due to the death of a mining partner or the transfer of a mining
partner’s interest.
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4.
Joint Venture
The definition of a partnership under Tex. GP Stats. includes a “joint venture” or any
other named association that satisfies the definition of “partnership.”302 A joint venture is legally
nothing more than a limited purpose partnership, although a joint venture may be organized as a
corporation, limited partnership, LLP or LLC.303 Because a joint venture is a type of partnership
and loss sharing is not necessary to form a partnership, Tex. GP Stats. effectively overrule cases
in the line represented by Coastal Plains Development Corp. v. Micrea, Inc.304 They also
resolve old questions about whether an agreement to share losses was necessary to create a
partnership by providing that it is unnecessary.305
B.
Taxation
1.
General Rule
A general partnership is basically a conduit for purposes of the liability of its members
and the payment of income taxes.
2.
Joint Venture/Tax Implications
Mining partnerships can exist in conjunction with other defined relationships. For
example, even though parties may have adopted a joint operating agreement which
disclaims any partnership relationship, a mining partnership may exist nonetheless by
operation of law.
The disclaimer of partnership between joint oil and gas interest owners became an
accepted and trusted principle of oil and gas law. If there were any doubts about the
contract provision, one only had to refer to the Texas Uniform Partnership Act, which
stated that “operation of a mineral property under a joint operating agreement does not of
itself establish a partnership.” The idea that no mining partnership existed in joint oil and
gas operations became so well accepted that there have been very few recent mining
partnership cases in Texas, and those that do exist generally support this conventional
wisdom.
Notwithstanding the conventional wisdom, however, mining partnerships are
being created, and they remain in existence even in the face of the standard “boiler plate”
denials of partnership. If the elements of mining partnership exist, then the mining
partnership exists as a matter of law without regard to the intent of the parties thereto.
Further, joint oil and gas operations are often commenced and carried out without
the adoption of a joint operating agreement. When this occurs, the probability that the
parties to an undocumented joint operation have created a mining partnership is
significantly increased. * * *
302
303
304
305
In order for a mining partnership to exist in Texas, five elements must be proven:
(1) joint ownership, (2) joint operations, (3) sharing of profits and losses, (4) community of
interests, and (5) mutual agency.
TRPA § 2.02; TBOC § 152.051(b).
See ALAN R. BROMBERG & LARRY E. RIBSTEIN, BROMBERG & RIBSTEIN ON PARTNERSHIP § 2.06 (Aspen
Publishers 2003).
See Coastal Plains Dev. Corp. v. Micrea, Inc., 572 S.W.2d 285, 287–88 (Tex. 1978).
TRPA § 2.03(c); TBOC § 152.052(c).
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A joint venture is commonly thought of as a limited duration partnership formed for a
specific business activity.306 It is treated for federal income tax purposes like a general
partnership in that the entity pays no tax; rather, its income or loss is allocated to the joint
venturers.307
3.
Contributions of Appreciated Property
As a general rule, a transfer of appreciated property in exchange for an interest in a
general partnership will not result in any gain or loss being recognized by the transferor, the
partnership, or any of the other partners of the partnership.308 The tax basis of the transferor in
his partnership interest and of the partnership in the transferred property is the basis the
transferor had in the transferred property at the time of the transfer.309 Under certain
circumstances, a partner’s contribution of property may result in a net reduction in liability to
that partner in excess of the partner’s tax basis in the contributed property. In such a situation,
the partner will recognize a gain to the extent of such excess. In addition, certain contributions
can be treated as “disguised sales” of all or a portion of the contributed property by the partner to
the partnership if the partner receives cash or other property, in addition to a partnership interest,
in connection with the transfer.
4.
Texas Entity Taxes
A general partnership was not obligated to pay Texas franchise taxes before January 1,
2007.310
The Margin Tax is not applicable to a general partnership if all of its partners are
individuals.311 The Margin Tax is imposed on a general partnership which has a business entity
as a partner.312
5.
Self-Employment Tax
Partners of a general partnership generally will be subject to self-employment tax on their
share of the net earnings of trade or business income of the partnership and any guaranteed
payments for personal services.313
C.
306
307
308
309
310
311
312
313
Owner Liability Issues
See, e.g., Tompkins v. Comm’r, 97 F.2d 396 (4th Cir. 1938); United States v. U. S. Nat’l Bank of Portland,
Or., 239 F.2d 475, 475–80 (9th Cir. 1956).
I.R.C. § 7701(a)(2) (2006).
I.R.C. § 721(a) (1997). But see Treas. Reg. § 1.707-3 (2003) (discussing disguised sales).
I.R.C. § 722 (1984); I.R.C. § 723 (1984).
TEX. TAX CODE ANN. § 17.001(a)(1) (Vernon 2002 & Supp. 2004); but see discussion supra Part I.
General—D. Federal “Check-the-Box” Tax Regulations”—2. Check-the-Box Regulations.
See discussions supra Part I. General—E. Texas Entity Taxation—3. Margin Tax and Part VI. Limited
Liability Partnership—D. Requirements for LLP Status—2. Filing with the Secretary of State of Texas.
See discussions supra Part I. General—E. Texas Entity Taxation—3. Margin Tax and Part VI. Limited
Liability Partnership—D. Requirements for LLP Status—2. Filing with the Secretary of State of Texas.
I.R.C. § 1402(a) (2004).
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Under Tex. GP Stats.,314 and typically under common law, a general partnership as an
entity is liable for loss or injury to a person, as well as for a penalty caused by or incurred as a
result of a wrongful act or omission of any of its partners acting either in the ordinary course of
the business of the partnership or with authority of the partnership. Generally, except as
provided for an LLP, which is hereinafter discussed, all partners of a general partnership are
jointly and severally liable for all debts and obligations of the partnership unless otherwise
agreed by a claimant or otherwise provided by law.315 Provisions in a partnership agreement that
serve to allocate liability among the partners are generally ineffective against third-party
creditors.316 A partner who is, however, forced to pay more than his allocable share of a
particular liability should have a right of contribution under Tex. GP Stats. from the partnership
or the other partners who did not pay their allocable share.317
A person admitted as a new partner into an existing general partnership in Texas does not
have personal liability for an obligation of the partnership that arose before his admission if the
obligation relates to an action taken or omission occurring prior to his admission or if the
obligation arises before or after his admission under a contract or commitment entered into
before his admission.318
A general partner who withdraws from the partnership in violation of the partnership
agreement is liable to the partnership and the other partners for damages caused by the wrongful
withdrawal.319 A withdrawn general partner may also be liable for actions committed by the
partnership while he was a partner, including malpractice, even though the action was not
adjudicated to be wrongful until after the partner withdrew from the firm.320
In a change from old Texas law, a creditor under current Tex. GP Stats. must exhaust
partnership assets before collecting a partnership debt from an individual partner on his or her
joint and several liability, except in limited circumstances.321 Previously, a creditor could obtain
a judgment enforceable against an individual partner’s assets without suing the partnership.322
314
315
316
317
318
319
320
321
322
TRPA § 3.03; TBOC § 152.303.
TRPA § 3.04; TBOC § 152.304.
J. CARY BARTON, TEXAS PRACTICE GUIDE: BUSINESS ENTITIES § 20.205 (2003); see Fincher v. B & D Air
Conditioning & Heating Co., 816 S.W.2d 509, 512 (Tex. App.—Houston [1st Dist.] 1991, writ denied).
TRPA §§ 4.01(c), 8.06(c); TBOC §§ 152.203(d), 152.708.
TRPA § 3.07; TBOC § 152.304(b).
TRPA § 6.02(c).
In re Keck, Mahin & Cate, 274 B.R. 740, 745–47 (Bankr. N.D. Ill. 2002). In Keck, the court explained:
A partner cannot escape liability simply by leaving the partnership after the malpractice
is committed but before the client wins or settles a malpractice claim . . . . Courts have
consistently held that, within the context of partnership dissolution, withdrawing partners
remain liable for matters pending at the time of dissolution . . . [t]he general rule under
Illinois law is that dissolution of the partnership does not of itself discharge the existing
liability of any partners . . . partners cannot release one another from liability to [nonconsenting] third parties.
See also Molly McDonough, Judge Orders Former Partners to Pay Creditors of Bankrupt Chicago Firm, 1
No. 9 ABA J. E-REPORT 1 (2002) (describing reactions to the Keck decision).
TRPA § 3.05; TBOC § 152.306.
See statutes cited supra note 1.
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Generally, Tex. GP Stats. require that there be a judgment against the partnership and that the
individual partner has been served in that action; however, a judgment against a partnership is
not automatically a judgment against its partners.323
Even with the improvements of Tex. GP Stats., it is the unlimited liability exposure of
partners in a general partnership that provides the most disadvantageous element of doing
business in a the form of a general partnership.
D.
Management
Partners have wide latitude to provide in the partnership agreement how the partnership is
to be managed. Unless the partnership agreement provides otherwise, each partner has an equal
right to participate in the management of the business.324 In such a situation, management of the
partnership is decentralized. Often, however, partners will designate a managing partner or
partners who will have the authority to manage the business of the partnership, creating a more
centralized management structure. Because a partner is an agent of the partnership, he or she
may bind the partnership in the ordinary course of its business unless the partner has no authority
to so act and the third party with whom the partner is dealing has knowledge that the partner has
no authority to so act.325 In the event that a partner exceeds his or her authority to act, the other
partners may have a cause of action against such partner for breach of the partnership agreement,
although this does not alter the fact that the partnership may be bound by the acts of the partner
that exceeded his or her authority.326
E.
Fiduciary Duties
1.
General
Under Tex. GP Stats., a partner owes duties of loyalty and care to the partnership, the
other partners, and the heirs, legatees or personal representatives of a deceased partner to the
extent of their respective partnership interests.327 These duties are fiduciary in nature although
not so labeled.328
2.
Loyalty
The duty of loyalty requires a general partner to place the interests of the partnership
ahead of his own interests.329 It requires a partner to account to the partnership for any
323
324
325
326
327
328
329
TRPA § 3.05(c); TBOC § 152.306(a).
TRPA § 4.01(d); TBOC § 152.203(a).
TRPA § 3.02; TBOC §§ 152.301–.302.
TRPA § 4.05; TBOC §§ 152.210, 152.302.
TRPA § 4.04; TBOC § 152.204.
See Johnson v. Brewer & Pritchard, P.C., 73 S.W.3d 193, 199–200 (Tex. 2002) (asserting that since the
court historically has held that partners owe certain fiduciary duties to other partners, it did not have to
consider the impact of the TRPA on such duties).
Meinhard v. Salmon, 249 N.Y. 458, 463-464, 164 N.E. 545, 546 (1928), in which Justice Cardozo wrote:
Joint adventurers, like copartners, owe to one another, while the enterprise
continues, the duty of the finest loyalty. Many forms of conduct permissible in a
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partnership asset received or used by the partner, and prohibits a partner from competing with the
partnership or dealing with the partnership in an adverse manner. The following fact patterns
may evidence a breach of the fiduciary duty of loyalty in the general partnership context on the
part of general partners, creating liability to the partnership or the other partners:
•
Self-dealing or profiting from dealing with the partnership in ways not contemplated by
the partnership agreement;
•
Appropriation of partnership opportunities;
•
Refusal to distribute profits to other members of the partnership;
•
Diversion of an asset of the partnership for a non-intended use;
•
Failure to disclose plans and conflicts to partners; and
•
A general lack of candor with partners.330
3.
Care
The duty of care requires a partner to act as an ordinarily prudent person would act under
similar circumstances.331 A partner is presumed to satisfy the duty of care if the partner acts on
an informed basis, in good faith, and in a manner the partner reasonably believes to be in the best
interest of the partnership.332
4.
Candor
In addition to the duties of loyalty and care, a partner owes his co-partners a fiduciary
duty of candor, sometimes referred to as a duty of disclosure.333
5.
Liability
A partner is liable to the partnership and the other partners for violation of a statutory
duty that results in harm to the partnership or the other partners and for a breach of the
partnership agreement.334 Tex. GP Stats. provide that a partner, in that capacity, is not a trustee
330
331
332
333
334
workaday world for those acting at arm’s length, are forbidden to those bound by
fiduciary ties. A trustee is held to something stricter than the morals of the market place.
Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of
behavior. As to this there has developed a tradition that is unbending and inveterate.
* * * Only thus has the level of conduct for fiduciaries been kept at a level higher than
that trodden by the crowd. It will not consciously be lowered by any judgment of this
court.
See TRPA § 4.04(b); TBOC § 152.205; BROMBERG & RIBSTEIN, supra note 389, at § 6.07.
TRPA § 4.04(c); TBOC § 152.206(a).
TRPA § 4.04(c), (d); TBOC §§ 152.204(b), 152.206(c).
BROMBERG & RIBSTEIN, supra note 389, at §§ 6.05(c) and 6.06.
TRPA § 4.05 ; TBOC § 152.210.
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and is not held to the same standards as a trustee,335 which represents a change from cases under
TUPA.336 A managing partner stands in a higher fiduciary relationship to other partners than
partners typically occupy.337
6.
Effect of Partnership Agreement
A partnership agreement governs the relations of the partners, but may not (i)
unreasonably restrict a partner’s statutory rights of access to books and records, (ii) eliminate the
duty of loyalty, although the agreement may within reason identify specific types or categories of
activities that do not violate the duty of loyalty, (iii) eliminate the duty of care, although the
agreement may within reason determine the standards by which the performance of the
obligation is to be measured, (iv) eliminate the obligation of good faith, although the agreement
may within reason determine the standards by which the performance of the obligation is to be
measured, (v) vary the power to withdraw as a partner, except to require the notice be in writing,
or (vi) vary certain other requirements.338
F.
Ability To Raise Capital
Because partnership interests are not freely transferable, at least with respect to
management powers, and due to the unlimited liability and decentralized management features of
a partnership, the partnership is a not the most advantageous entity for raising capital. The
general partnership, however, does have the advantage in dealing with lenders in that all partners
are individually liable, jointly and severally, for the partnership’s debts, absent a contractual
limitation of liability in the case of any particular debt.
G.
Transferability of Ownership Interests
1.
Generally
A partnership interest is transferable by a partner; however, a partner’s right to participate
in the management of the partnership may not be assigned without the consent of the other
partners.339 Texas law differentiates between a transfer of a partner’s partnership interest and the
admission of a successor as a general partner. A transferee is neither able to participate in
management nor liable as a partner solely because of a transfer unless and until he becomes a
partner, but such transferee is entitled to receive, to the extent transferred, distributions to which
335
336
337
338
339
TRPA § 4.04(f); TBOC § 152.204(d).
See Huffington v. Upchurch, 532 S.W.2d 576, 579 (Tex. 1976); Crenshaw v. Swenson, 611 S.W.2d 886, 890
(Tex. Civ. App.—Austin 1980, writ ref’d n.r.e.) (holding that a managing partner owes his co-partners the
highest fiduciary duty recognized in the law).
See, e.g., Hughes v. St. David’s Support Corp., 944 S.W.2d 423 (Tex. App.—Austin 1997, writ denied);
Conrad v. Judson, 465 S.W.2d 819, 828 (Tex. Civ. App.—Dallas 1971, writ ref’d n.r.e.); Huffington, 532
S.W.2d at 579; see also Brazosport Bank of Tex. v. Oak Park Townhouses, 837 S.W.2d 652, 659 (Tex.
App.—Houston [14th Dist.] 1992), rev’d on other grounds, 851 S.W.2d 189 (Tex. 1993) (noting that a
fiduciary relationship exists between general partners, as well as between general and limited partners);
Crenshaw, 611 S.W.2d at 890.
TRPA § 1.03(b); TBOC § 152.002.
See TRPA § 5.03; TBOC §§ 152.401, 152.402(3).
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the transferor would otherwise be entitled.340 A transfer of a partnership interest is not
considered an event of withdrawal; therefore, transfer alone will not cause the winding up of the
partnership business.341 The partnership agreement will often contain a provision prohibiting a
partner from assigning his economic rights associated with the partnership interest. Unless
otherwise specified by the partnership agreement, all of the partners must consent to the
substitution of a new partner.342 General partnership interests may be evidenced by transferable
certificates, but ordinarily no such certificates are issued.343
2.
Partnership Interests as Securities
Under the Securities Act of 1933, the Securities Exchange Act of 1934, and most state
blue sky laws, the term “security” is defined to include an “investment contract.”344 Neither
federal securities act defines a partnership interest, whether general or limited, as a “security.”
However, by overwhelming precedent, limited partnership interests are considered investment
contracts for purposes of the securities laws.345 The question of whether a general partnership
interest is a security requires a case-by-case analysis. A general partner interest may be a
security when the venture, although a general partnership de jure, functions de facto as a limited
partnership (i.e., certain partners do not actively participate in management and rely primarily on
the efforts of others to produce profits). In Williamson v. Tucker,346 the court stated that a
general partnership or joint venture interest may be categorized as a security if the investor can
show that:
(1) an agreement among the parties leaves so little power in the hands of the
partner or venturer that the arrangement in fact distributes power as would a
limited partnership; or (2) the partner or venturer is so inexperienced and
unknowledgeable in business affairs that he is incapable of intelligently exercising
his partnership or venture powers; or (3) the partner or venturer is so dependent
on some unique entrepreneurial or managerial ability of the promoter or manager
that he cannot replace the manager of the enterprise or otherwise exercise
meaningful partnership or venture powers.347
While quoting from the Williamson case, the Rivanna Trawlers Unlimited v. Thompson
Trawlers, Inc. court further stated that when a “partnership agreement allocates powers to the
general partners that are specific and unambiguous, and when those powers are sufficient to
340
341
342
343
344
345
346
347
See TRPA §§ 5.02–.04; TBOC §§ 152.402(3), 152.404(a), (c).
TRPA § 5.03(a); TBOC § 152.402(1), (2).
TRPA § 4.01(g); TBOC § 152.201.
TRPA § 5.02(b); TBOC § 3.201.
Securities Act of 1933, 15 U.S.C. § 77b(a)(1) (2000); Securities Exchange Act of 1934, 15 U.S.C. §
78c(a)(10) (2000).
See S.E.C. v. Murphy, 626 F.2d 633, 640 (9th Cir. 1980) (concluding that shares in LPs fall within the
definition of “securities,” as investors had no managerial role); Stowell v. Ted S. Finkel Inv. Servs., Inc.,
489 F. Supp. 1209, 1220 (S.D. Fla. 1980), aff’d, 64 F.2d 323 (5th Cir. 1981) (stating that the issue is
whether the limited partnership interest meets the test of an investment contract).
Williamson v. Tucker, 645 F.2d 404, 424 (5th Cir. 1981) cert. denied, 454 U.S. 897 (1981).
But cf., Rivanna Trawlers Unlimited v. Thompson Trawlers, Inc., 840 F.2d 236 (4th Cir. 1988).
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allow the general partners to exercise ultimate control, as a majority, over the partnership and its
business, then the presumption that the general partnership is not a security can only be rebutted
by evidence that it is not possible for the partners to exercise those powers.”348 The results
should not be affected by the fact that some of the general partners may have remained
passive,349 or that the general partnership had made an LLP election.350
H.
Continuity of Life
Under Tex. GP Stats., a partnership will continue after the withdrawal of a partner or an
event requiring a winding up of the business of the partnership until the winding up of the
partnership has been completed.351 The statutes provide for “events of withdrawal” and “events
of winding up.”352 Upon the occurrence of an event of withdrawal, the business of the
partnership is not required to be wound up.353 An event of withdrawal occurs (i) upon the
occurrence of events specified in the partnership agreement, (ii) when the partnership receives
notice of a partner’s election to withdraw, (iii) upon the expulsion of a partner by partner vote or
judicial decree in statutorily specified circumstances, or (iv) upon the death or bankruptcy of a
partner, among other events.354 Except for the partner’s right to withdraw, the statutory events of
withdrawal may be modified by the partnership agreement,355 and in view of the Check-the-Box
Regulations, modification may become increasingly appropriate and common. Although a
partner may withdraw from the partnership at any time, the withdrawal may subject the
withdrawing partner to liability and various penalties if he or she violates the partnership
agreement or the withdrawal is otherwise wrongful.356 Unless the partnership agreement
provides otherwise,357 the interest of a withdrawing partner, except for a partner who wrongfully
withdraws, must be redeemed by the partnership at fair market value.358 An event of winding up
occurs when, among other things, a majority in interest of the partners elect to wind up the
partnership if the partnership does not have a specified duration, the term of the partnership
expires, the partnership agreement calls for a winding up in a particular situation or all or
substantially all of the assets of the partnership are sold outside the ordinary course of its
business.359
I.
348
349
350
351
352
353
354
355
356
357
358
359
Formation
Id. at 241.
Id.
Cf. S.E.C. v. Merchant Capital, LLC, 400 F. Supp.2d 1336 (N.D. Ga. 2005).
TRPA §§ 2.06(a), 8.02; TBOC §§ 152.502, 152.701.
TRPA §§ 1.01(6)–(7); 6.01(b), 8.01; TBOC §§ 11.051, 11.057, 152.501(b).
TRPA § 2.06(a), TBOC § 152.502.
TRPA § 6.01; TBOC § 152.501(b).
TRPA § 1.03; TBOC § 152.002.
TRPA § 6.02; TBOC § 152.503.
TRPA § 1.03; TBOC § 152.002.
TRPA § 7.01; TBOC §§ 152.601–.602. In the case of a partner who wrongfully withdraws, the redemption
price is the lesser of fair market value or liquidation value. Id.
TRPA § 8.01; TBOC §§ 11.051, 11.057.
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A general partnership can be one of the simplest, least expensive business entities to form
because the existence of a partnership does not depend on the existence or filing of any particular
document; rather, a partnership depends on the existence of an association of two or more
persons carrying on, as co-owners, a business for profit.360 The factors discussed in Part III.A.
are used to determine whether or not a general partnership exists.361 Thus, it is not necessary that
any written partnership agreement exists or that any significant expenses be incurred in the
formation of a partnership.362 Most of the time, however, partners will wish to have their
relationship governed by a partnership agreement rather than rely on the default statutory
provisions, and partnership agreements can be very complex.
Under Tex. GP Stats., a partnership agreement, which does not have to be in writing,
governs the relations of the partners and the relations between the partners and the partnership; to
the extent the partnership agreement does not otherwise provide, Tex. GP Stats. governs those
relationships.363 The partnership agreement, however, may not (i) unreasonably restrict a
partner’s statutory rights of access to books and records, (ii) eliminate the duty of loyalty,
although the agreement may within reason identify specific types of activities that do not violate
the duty of loyalty, (iii) eliminate the duty of care, although the agreement may within reason
determine the standard by which the performance of the obligation is to be measured, (iv)
eliminate the obligation of good faith, although the agreement may within reason determine the
standard by which the performance of the obligation is to be measured, (v) vary the power to
withdraw as a partner, except to require the notice be in writing, or (vi) vary certain other
requirements.364 Public policy limitations in some cases may limit the extent to which a
partnership agreement may effectively reduce the fiduciary duties of a partner.
Unless the partnership agreement specifically provides otherwise, profits and losses of a
general partnership are shared per capita and not in accordance with capital contributions or
capital accounts.365
Because partners are granted wide contractual freedom to specify the terms of their
partnership, “standard” partnership agreements are less likely to be useful. Additionally, the
time and expense of preparing a partnership agreement can be significant. For these reasons, the
cost of organizing a general partnership is usually higher than the cost of organizing a
corporation.
J.
Operations in Other Jurisdictions
A general partnership does not qualify to do business as a foreign general partnership
under the laws of other states, although the partnership may have to file tax returns and the
partners may be subject to taxation in the other states in which the partnership does business.366
360
361
362
363
364
365
TRPA § 2.02(a); TBOC § 152.051.
TRPA § 2.03(a); TBOC § 152.052(a).
See Pappas v. Gounaris, 301 S.W.2d 249, 254 (Tex. Civ. App.—Galveston 1957, writ ref’d n.r.e.).
TRPA § 1.03(a); TBOC § 152.002(a).
TRPA § 1.03(b); TBOC § 152.002(b).
See TRPA § 4.01(b); TBOC § 152.202(c).
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K.
Business Combinations
Texas law now authorizes a partnership to merge with a corporation, LLC or another
partnership, as well as to convert from one form of entity into another without going through a
merger or transfer of assets.367 Article IX of the TRPA and chapter 10 of the TBOC include
provisions relating to the mechanics of adopting a plan of merger or conversion, obtaining owner
approval, filing with the Secretary of State and protecting creditors.368
IV.
LIMITED PARTNERSHIP
A.
General
A “limited partnership” is a partnership formed by two or more persons, with one or more
general partners and one or more limited partners.369 Limited partnerships are statutorily
authorized entities. Most states have adopted some form of the Uniform Limited Partnership Act
or the Revised Uniform Limited Partnership Act to govern the rights, duties and liabilities of
limited partnerships organized under such statutes. In Texas, domestic limited partnerships are
governed by either the TRLPA or the TBOC.370 Because until 2010 some limited partnerships
will be governed by the TRLPA and others by the TBOC and because the substantive principles
under both statutes are generally the same, the term “Tex. LP Stats.” is used herein to refer to the
TBOC and the TRPA collectively, and the particular differences between the TRLPA and the
TBOC are referenced as appropriate.
Similarly to other entities under Texas law, limited partnerships formed prior to January
1, 2006 which do not voluntarily opt into the TBOC will continue to be governed by the TRLPA
until January 1, 2010.371 All other Texas limited partnerships, including those resulting from a
conversion that is effective on or after January 1, 2006, are governed by the TBOC.372
B.
Taxation
1.
Federal Income Taxation
A domestic limited partnership would ordinarily be treated as a partnership for federal
income tax purposes under the Check-the-Box Regulations so long as it has two or more
partners.373
366
367
368
369
370
371
372
373
Cf. TRPA § 9.05(a) (acknowledging that the laws of other states apply to a partnership looking to be bound by
that jurisdiction’s law as a domestic partnership); see also TBOC § 10.101(d).
TRPA §§ 9.01–.06; TBOC Chapter 10.
Id.; TBOC §§ 10.001–.009; 10.101–.151; 10.154–.201.
TRLPA § 1.02(6); TBOC § 1.002(50).
The TBOC provisions relating to limited partnerships are Title 1 and Chapters 151, 153 and 154, as well as
certain provisions of Chapter 152. Such provisions may officially and collectively be referred to as “Texas
Limited Partnership Law”. TBOC § 1.008(g).
TRLPA § 13.10.
TBOC §§ 401.001, 402.003.
See Treas. Reg. § 301.7701-2(c)(1) (as amended in 2003).
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2.
Contributions of Appreciated Property
With respect to contributions of appreciated property, the same rule applies to limited
partnerships as applies to general partnerships: ordinarily, a transfer of appreciated property in
exchange for an interest in a limited partnership will not result in any gain or loss being
recognized by the transferor, the partnership, or any of the other partners of the partnership.374
The tax basis of the transferor in his partnership interest, and of the partnership in the transferred
property, is the basis the transferor had in the transferred property at the time of the transfer.375
Under certain circumstances, a partner’s contribution of property may result in a net reduction in
liability376 to that partner in excess of the partner’s tax basis in the contributed property. In such
a situation, the partner will recognize a gain to the extent of such excess.377 In addition, certain
contributions can be treated as “disguised sales” of all or a portion of the contributed property by
the partner to the partnership if the partner receives cash or other property, in addition to a
partnership interest, in connection with the transfer.
3.
Texas Entity Taxes
A limited partnership was not subject to the Texas franchise tax before January 1,
2007.378
Effective for tax years beginning on or after January 1, 2007, the Margin Tax replaces the
Texas franchise tax and is imposed on limited partnerships.379
4.
Self-Employment Tax
A limited partner’s share of income of the limited partnership, other than a guaranteed
payment for services, is generally not subject to the self-employment tax.380 Guaranteed
payments made to a limited partner by the partnership for services rendered and the general
partner’s share of the net earnings of trade or business income of a limited partnership generally
will be subject to self-employment tax. On January 13, 1997, the IRS issued proposed
regulations under IRC § 1402 that would define “limited partner” for employment tax purposes
as follows, irrespective of the partner’s status under state law, as follows:
Generally, an individual will be treated as a limited partner under the
proposed regulations unless the individual (1) has personal liability (as defined in
§ 301.7701-3(b)(2)(ii) of the Procedure and Administration Regulations) for the
debts of or claims against the partnership by reason of being a partner; (2) has
authority to contract on behalf of the partnership under the statute or law pursuant
374
375
376
377
378
379
380
I.R.C. § 721(a) (1997). But see Treas. Reg. § 1.707-3 (1992) (discussing disguised sales).
I.R.C. § 722 (1986); I.R.C. § 723 (1986).
I.R.C. § 752 (1986).
I.R.C. § 731 (1997).
See TEX. TAX CODE ANN. § 171.001 (Vernon 2002 & Supp. 2004).
See discussion supra Part I. General—E. Texas Entity Taxation—3. Margin Tax.
I.R.C. § 1402(a)(13) (2007); see Robert G. Fishman, Self-Employment Tax, Family Limited Partnerships and
the Partnership Anti-Abuse Regulations, 74 TAXES 689 (1996).
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to which the partnership is organized; or, (3) participates in the partnership’s trade
or business for more than 500 hours during the taxable year. If, however,
substantially all of the activities of a partnership involve the performance of
services in the fields of health, law, engineering, architecture, accounting,
actuarial science, or consulting, any individual who provides services as part of
that trade or business will not be considered a limited partner.381
The proposed regulations would also allow an individual who fails the test for limited partner
status to bifurcate the partnership interest into two classes, one of which could qualify for
exclusion from employment taxes if it were demonstrably related to invested capital rather than
services.382
The Taxpayer Relief Act of 1997 prohibited the IRS from issuing any temporary or final
regulations relating to the definition of a limited partner for employment tax purposes that would
be effective before July 1, 1998.383 The legislative history indicates that Congress wants the IRS
to withdraw the controversial proposed regulation discussed above, which would impose a tax on
limited partners.384 A “sense of the Senate” resolution in the Senate amendment expressed
dissatisfaction with the proposed regulation, noting that Congress, not the Treasury or the IRS,
should determine the law governing self-employment income for limited partners.385
C.
Owner Liability Issues
A general partner of a limited partnership has the same unlimited liability as does a
partner of a general partnership.386 By contrast, a limited partner’s liability for debts of or claims
against the partnership is limited to the limited partner’s capital contribution to the partnership
(plus any additional amounts agreed to be contributed).387 A limited partner may lose this
limited liability, however, if he or she participates in the management of partnership business.388
The safe harbor provisions of Tex. LP Stats. specify activities that will not subject a limited
partner to unlimited liability, such as consulting with and advising a general partner, acting as a
contractor for or an agent or employee of the limited partnership or of a general partner,
proposing, approving, or disapproving certain specified matters related to the partnership
business or the winding up of the partnership business or guaranteeing specific obligations of the
381
382
383
384
385
386
387
388
Definition of Limited Partner for Self-Employment Tax Purposes, Prop. Treas. Reg. 1.1402(a)-2(h), 62
Fed. Reg. 1702-01 (Jan. 13, 1997).
Prop. Treas. Reg. 1.1402(a)-2(h).
Taxpayer Relief Act of 1997, Pub. L. 105–34, 111 Stat. 788 (1997) (enacted).
Taxpayer Relief Act of 1997, H.R. 2014, 105th Cong. § 734 (1997) (enacted).
S. 949, 105th Cong. § 734 (1997).
See TRLPA §§ 4.01(d), 4.03(a); TBOC § 153.152. See KAO Holdings, L.P. v. Young, 214 S.W.3d 504 (Tex.
App.—Houston [14th Dist.] 2006), in which a court held that “in a suit against a partnership (general or
limited), citation may be served on any general partner of the partnership” and, quoting TRLPA § 3.05(c), “a
judgment may be entered against a [general] partner who has been served with process in a suit against a
partnership” even though the general partner was neither named or served individually in the lawsuit.
See TRLPA § 3.03; TBOC § 153.102.
TRLPA § 3.03; TBOC § 153.102.
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limited partnership.389 Even if the limited partner’s activities exceed the safe harbors, the limited
partner will only have unlimited liability to those third parties dealing with the limited
partnership who have actual knowledge of the limited partner’s participation and control and
who reasonably believe that the limited partner is a general partner based on the limited partner’s
conduct.390 Under the TRLPA, though not under the TBOC, a limited partner who knowingly
permits his name to be used in the name of the partnership will be liable to creditors who extend
credit to the limited partnership without actual knowledge that the limited partner is not a general
partner.391 A corporation can serve as the general partner of a limited partnership, although the
ordinary grounds for piercing the corporate veil (e.g. if the corporate general partner is not
sufficiently capitalized in light of known and contingent liabilities) may be applied to hold the
shareholders of such a corporate general partner liable in certain factual contexts.392
Tex. LP Stats. authorize a limited partnership to register as an LLP by complying with
the LLP provisions of TRPA or TBOC discussed below, whereupon the general partner would be
liable for the debts or obligations of the limited partnership only to the extent provided in TRPA
section 3.08(a) or TBOC section 152.801.393
D.
Management
Control of a limited partnership is vested in the general partner or partners, who have all
the rights and powers of a partner in a general partnership.394 Therefore, management of a
limited partnership tends to be centralized in the general partner or partners, although safe harbor
provisions in most modern limited partnership statutes give limited partners greater latitude in
certain matters of management of the limited partnership than was given previously.395 Under
Tex. LP Stats., the partnership agreement may provide for multiple classes or groups of limited
partners having various rights or duties, including voting rights.396
E.
Fiduciary Duties
Case law has adopted fiduciary standards for general partners of limited partnerships
mirroring the unbending fiduciary standards espoused in general partnership cases.397 Because
389
390
391
392
393
394
395
396
397
TRLPA § 3.03(b); TBOC § 153.103.
TRLPA § 3.03(a); TBOC § 153.102(b).
TRLPA § 3.03(d); Revisor’s Note to TBOC § 153.102.
See Grierson v. Parker Energy Partners 1984-I, 737 S.W.2d 375, 377–78 (Tex. App.—Houston [14th Dist.]
1987, no writ) (stating that in tortious activity, the corporate veil of a corporate general partner need not be
pierced in order to impose liability, thus implying the veil may be pierced in other circumstances).
TRPA § 3.08(e); TRLPA §2.14; TBOC §§ 152.805, 153.351, 153.353.
TRLPA § 4.03(a); TBOC § 153.152.
TRLPA § 3.03; TBOC §§ 153.102, 153.103.
TRLPA § 3.02; TBOC § 154.101.
See Hughes v. St. David’s Support Corp., 944 S.W.2d 423, 425–26 (Tex. App.—Austin 1997, writ denied)
(holding that “in a limited partnership, the general partner stands in the same fiduciary capacity to the
limited partners as a trustee stands to the beneficiaries of a trust.”); McLendon v. McLendon, 862 S.W.2d
662, 676 (Tex. App.–—Dallas 1993, writ denied) (holding that “in a limited partnership, the general partner
acting in complete control stands in the same fiduciary capacity to the limited partners as a trustee stands to
the beneficiaries of a trust.”); Crenshaw v. Swenson, 611 S.W.2d 886, 890 (Tex. Civ. App.—Austin 1980,
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of their control over partnership affairs, general partners may be subjected to an even higher
fiduciary standard with respect to limited partners.398 Those in control of the general partner
have been held to the same high standards.399
Because a general partner in a limited partnership has the powers, duties and liabilities of
a partner in a general partnership unless applicable law or the partnership agreement provides
otherwise, a general partner in a limited partnership has the duties of care and loyalty set forth in
TRPA section 4.04 and TBOC section 152.204, which basically codify those duties without
giving them the “fiduciary” appellation.400 Since Tex. LP Stats. provide that a general partner’s
conduct is not to be measured by trustee standards, it may no longer be appropriate to measure
general partner conduct in terms of trustee fiduciary standards.401 Courts, however, continue to
refer to the trustee standard.402
A partner owes the duties of care and loyalty to the partnership and the other partners.403
Tex. LP Stats. define the duty of care as requiring a partner to act in the conduct and winding up
of the partnership business with the care of an ordinarily prudent person under similar
circumstances.404 An error in judgment does not by itself constitute a breach of the duty of
care.405 Further, a partner is presumed to satisfy the duty of care if the partner acts on an
informed basis, in good faith and in a manner the partner reasonably believes to be in the best
interest of the partnership.406 These provisions draw on the corporate business judgment rule in
articulating the duty of care. Nevertheless, Texas law does not specify whether the standard of
care is one of simple or gross negligence. The sparse case law in this area (pre-dating the TRPA)
indicates that a partner will not be held liable for mere negligent mismanagement.407
In Texas, the duty of loyalty is defined as including408:
398
399
400
401
402
403
404
405
406
407
408
writ ref’d n.r.e.); Watson v. Limited. Partners of WCKT, Ltd., 570 S.W.2d 179, 182 (Tex. Civ. App.—
Austin 1978, writ ref’d n.r.e.); Robert W. Hamilton, Corporate General Partners of Limited Partnerships,
1 J. SMALL & EMERGING BUS. L. 73, 73 (1997) (stating that “[g]eneral partners are personally liable for all
partnership obligations, including breaches of fiduciary duties owed to the limited partners”); see also
Huffington v. Upchurch, 532 S.W.2d 576 (Tex. 1976); Johnson v. Peckham, 120 S.W.2d 786 (Tex. 1938);
Kunz v. Huddleston, 546 S.W.2d 685 (Tex. Civ. App.—El Paso 1977, writ ref’d n.r.e.).
In Palmer v. Fuqua, 641 F.2d 1146, 1155 (5th Cir. 1981), the Fifth Circuit noted that under Texas law a
general partner having exclusive power and authority to control and manage the limited partnership
“owe[s] the limited partners an even greater duty than is normally imposed [upon general partners].”
See In re Bennett, 989 F.2d 779, 790 (5th Cir. 1993) (explaining that when a partner is in complete control
of the partnership, the partner owes the highest level of fiduciary duty).
TRLPA §§ 4.03(b), 13.03; TBOC §§ 153.003, 153.152.
TRPA § 4.04(f); TBOC § 152.204(d).
See Hughes v. St. David’s Support Corp., 944 S.W.2d 423, 425–26 (Tex. App.—Austin 1997, writ denied).
TRPA § 4.04(a); TBOC § 152.204(a).
TRPA § 4.04(c); TBOC § 152.206(a).
TRPA § 4.04(c); TBOC § 152.206(a).
TRPA § 4.04(c)–(d); TBOC §§ 152.204(b), 152.206.
See Ferguson v. Williams, 670 S.W.2d 327, 331 (Tex. App.—Austin 1984, writ ref’d n.r.e.).
TRPA § 4.04(b); TBOC § 152.205.
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1.
accounting to the partnership and holding for it any property, profit, or benefit
derived by the partner in the conduct and winding up of the partnership business
or from use by the partner of partnership property;
2.
refraining from dealing with the partnership on behalf of a party having an
interest adverse to the partnership; and
3.
refraining from competing with the partnership or dealing with the partnership in
a manner adverse to the partnership.
These provisions mirror the common areas traditionally encompassed by the duty of loyalty (e.g.,
self-dealing, conflicts of interest and usurpation of partnership opportunity).409 To temper some
of the broader expressions of partner duties in older Texas case law and permit a balancing
analysis as in the corporate cases, Texas law specifically states that a partner does not breach a
duty merely because his conduct furthers his own interest and that the trustee standard should not
be used to test general partner conduct.410 It does, however, impose on a general partner in a
limited partnership the obligation to discharge any duty, and exercise any rights or powers, in
conducting or winding up partnership business in good faith and in a manner that the partner
reasonably believes to be in the best interest of the partnership.411
The TBOC makes it clear that limited partners, as limited partners, generally do not owe
fiduciary duties to the partnership or to other partners.412 Previously, a literal reading of the
TRPA and TRLPA suggested that limited partners owed such duties by virtue of the linkage of
TRPA to TRLPA under TRLPA section 13.03. That literal interpretation of the statutes,
however, was contrary to the general concept that limited partners are merely passive investors
and thus should not be subjected to liability for their actions as limited partners. Further, even
before the TBOC was enacted there was some case law to the effect that limited partners do not
have fiduciary duties.413 An exception is made to this general rule in the case where a limited
partner actually has or exercises control in management matters (e.g., because of control of the
general partner, contractual veto powers over partnership actions or service as an agent of the
partnership). In such situations, the limited partner’s conduct may be judged by fiduciary
principles.414
409
410
411
412
413
414
Under Texas law, persons engaged in a partnership owe to one another one of the highest duties recognized
in law—the duty to deal with one another with the utmost good faith and most scrupulous honesty. See
Huffington v. Upchurch, 532 S.W.2d 576, 579 (Tex. 1976); Smith v. Bolin, 271 S.W.2d 93, 96 (Tex.
1954); Johnson v. J. Hiram Moore, Ltd., 763 S.W.2d 496 (Tex. App.—Austin 1988, writ denied); see also
Brazosport Bank of Tex. v. Oak Park Townhouses, 837 S.W.2d 652, 659 (Tex. App.—Houston [14th Dist.]
1992, writ granted), rev’d on other grounds, 851 S.W.2d 189 (Tex. 1993); Crenshaw v. Swenson, 611
S.W.2d 886, 890 (Tex. Civ. App.—Austin 1980, writ ref’d n.r.e.).
TRPA § 4.04(e)–(f); TBOC § 152.204(c)–(d).
TRPA § 4.04(d); TBOC § 152.204(b).
TBOC § 153.003(b), (c).
See, e.g., In re Villa West Assocs., 146 F.3d 798, 806 (10th Cir. 1998); In re Kids Creek Partners, L.P., 212
B.R. 898, 937 (Bankr. N.D. Ill. 1997).
See RJ Assocs., Inc. v. Health Payors’ Org. Ltd. P’ship, HPA, Inc., No. 16873, 1999 WL 550350, at *10
(Del. Ch. July 16, 1999) (unpublished mem. op.) (suggesting that, unless a partnership agreement provides
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The Tex. LP Stats. state in part that except as provided in various statutory provisions or
the partnership agreement, a general partner of a limited partnership “has the liabilities of a
partner in a partnership without limited partners to the partnership and to the other partners.”415
This language indicates that the partnership agreement may modify the internal liabilities of a
general partner, but it is not clear whether it is an authorization without express limits or whether
it would link to Texas general partnership statutes that prohibit elimination of duties and set a
“manifestly unreasonable” floor for contractual variation.416 Delaware expressly allows the
limitation or elimination of partner fiduciary duties in the partnership agreement.417 Although
415
416
417
to the contrary, any limited partner owes fiduciary duties to the partnership); KE Prop. Mgmt. Inc. v. 275
Madison Mgmt. Inc., Civ. A. No. 12683, 1993 WL 285900, at *4 (Del. Ch. July 27, 1993) (unpublished
mem. op.). Limited partners who function as officers or managers of a limited partnership are typically
considered agents of the limited partnership, and as agents to owe fiduciary duties, including the duty of
loyalty, to the limited partnership and its other partners. See Restatement (Second) of Agency (1958)
§§ 13 (stating that “[a]n agent is a fiduciary with respect to matters within the scope of his agency”), 387
(stating that “[u]nless otherwise agreed, an agent is subject to a duty to his principal to act solely for the
benefit of the principal in all matters connected with his agency”), 393 (stating that “[u]nless otherwise
agreed, an agent is subject to a duty not to compete with the principal concerning the subject matter of his
agency”), 394 (stating that “[u]nless otherwise agreed, an agent is subject to a duty not to act or to agree to
act during the period of his agency for persons whose interests conflict with those of the principal in
matters in which the agent is employed”), and 395 (stating that “[u]nless otherwise agreed, an agent is
subject to a duty to the principal not to use or to communicate information confidentially given him by the
principal or acquired by him during the course of or on account of his agency or in violation of his duties
as agent, in competition with or to the injury of the principal, on his own account or on behalf of another,
although such information does not relate to the transaction in which he is then employed, unless the
information is a matter of general knowledge”); see also Daniel v. Falcon Interest Realty Corp., 190
S.W.3d 177 (Tex. App.—Houston [1st Dist.] 2005, no pet. hist).
TRLPA § 4.03(b); TBOC § 153.152(a). Note, this language should not be mistaken as an authorization for
partnership agreements to alter partner liabilities to third parties.
See TRPA § 1.03(b); TBOC § 152.002(b). One additional point applies to limited partnerships that
continue to be governed by the TRLPA. When originally drafted, it was the intent of the Partnership Law
Committee of the Business Law Section of the State Bar of Texas that the TRLPA be subject to variation
by agreement only if expressly permitted by the TRLPA; otherwise, the parties were not free to agree to
provisions in the partnership agreement that differ from those contained in the TRLPA. TRLPA § 4.03 bar
committee’s cmt. Given the subsequent adoption of the TRPA, with its more flexible approach to
contractual modifications of the statutory provisions, and the linkage provision contained in section 13.03
of the TRLPA, there is some question as to whether the more restrictive approach of the TRLPA to
contractual modifications continues to have any application. Cf. TRPA § 1.03 bar committee’s cmt. Thus, a
prudent course for limited partnerships formed before January 1, 2006 was to draft the partnership
agreement as if the flexibility afforded by the TRPA applied, but to be aware that any provisions of the
partnership agreement that varied the requirements of the TRLPA without express statutory authority were
subject to challenge.
“Partnership agreement” is defined to be either a written or oral agreement of the partners concerning the
affairs of the partnership and the conduct of its business. See TRLPA § 1.02(10); TBOC § 151.001(5)
(emphasis added).
Some TRLPA provisions permit modification by either a written or oral partnership agreement, while
others require the modification to be in the form of a written partnership agreement. Compare TRLPA
section 4.03(a) and TBOC section 153.152 concerning restrictions on a general partner with TRLPA
section 11.02 and TBOC section 8.103(c) concerning indemnification of a general partner.
Section 17-1101(b)–(f) of the Delaware Revised Limited Partnership Act (“DRLPA”), DEL. CODE ANN. tit.
6, section 17-1101(b)–(f) (Supp. 2007), provide as follows:
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(b) The rule that statutes in derogation of the common law are to be strictly
construed shall have no application to this chapter.
(c) It is the policy of this chapter to give maximum effect to the principle of
freedom of contract and to the enforceability of partnership agreements.
(d) To the extent that, at law or in equity, a partner or other person has duties
(including fiduciary duties) to a limited partnership or to another partner or to another
person that is a party to or is otherwise bound by a partnership agreement, the partner’s or
other person’s duties may be expanded or restricted or eliminated by provisions in the
partnership agreement; provided that the partnership agreement may not eliminate the
implied contractual covenant of good faith and fair dealing.
(e) Unless otherwise provided in a partnership agreement, a partner or other
person shall not be liable to a limited partnership or to another partner or to another
person that is a party to or is otherwise bound by a partnership agreement for breach of
fiduciary duty for the partner’s or other person’s good faith reliance on the provisions of
the partnership agreement.
(f) A partnership agreement may provide for the limitation of elimination of any
and all liabilities for breach of contract and breach of duties (including fiduciary duties)
of a partner or other person to a limited partnership or to another partner or to an other
person that is a party to or is otherwise bound by a partnership agreement; provided, that
a partnership agreement may not limit or eliminate liability for any act or omission that
constitutes a bad faith violation of the implied contractual covenant of good faith and fair
dealing.
DEL. CODE ANN. tit. 6, § 17-1101(b)–(f) (Supp. 2007).
See Myron T. Steele, Judicial Scrutiny of Fiduciary Duties in Delaware Limited Partnerships and Limited
Liability Companies, 32 Del. J. Corp. L. 1, 25 (2007), in which Delaware Supreme Court Chief Justice
Steele argues that parties forming limited partnerships and companies should be free to adopt or reject
some or all of the fiduciary duties recognized at common law in the context of corporations, that courts
should look to the parties’ agreement and apply a contractual analysis, rather than analogizing to traditional
notions of corporate governance, in limited partnership and LLC fiduciary duty cases, and that Delaware
courts should analyze limited partnership fiduciary duty cases as follows:
The courts' approach should be, first, to examine the agreement to determine if
the act complained of is legally authorized by statute or by the terms of the agreement
itself. If so, a court should then proceed to inquire whether the implementation of the
lawful act requires equity to intervene and craft a remedy? At this point, the court should
look to the agreement to determine the extent to which it establishes the duties and
liabilities of the parties, i.e., their bargained for, negotiated, contractual relationship. Is
the agreement silent about traditional fiduciary duties, but creates a fiduciary relationship
consistent with those duties thus allowing the court to imply them by default? Does the
agreement expand, restrict, or eliminate one or more of the traditional fiduciary duties? Is
the contract language creating those duties and liabilities so inconsistent with common
law fiduciary duty principles that it can be concluded that the parties consciously
modified them in a discernible way? If so, which duties and in what respect were they
modified? Finally, without regard to traditional overlays of scrutiny under the common
law of corporate governance, has a party breached its implied covenant of good faith and
fair dealing?
See infra note 545 regarding Chief Justice Steele’s views in respect of fiduciary duties in the LLC
context.
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limitations on fiduciary duty in a partnership agreement may be respected by courts when they
are expressly set forth in the four corners of the partnership agreement, “a topic as important as
this should not be addressed coyly.”418
418
Miller v. American Real Estate Partners, L.P., No. CIV.A.16788, 2001 WL 1045643, at *8 (Del. Ch. Sept.
6, 2001) (unpublished mem. op.). In Miller, the general partner contended that the partnership agreement
eliminated any default fiduciary duty of loyalty owed by the general partner to the limited partners in
section 6.13(d) of the partnership agreement, which read as follows:
Whenever in this Agreement the General Partner is permitted or required to make a
decision (i) in its “sole discretion” or “discretion”, with “absolute discretion” or under a
grant of similar authority or latitude, the General Partner shall be entitled to consider only
such interests and factors as it desires and shall have no duty or obligation to give any
consideration to any interest of or factors affecting the Partnership, the Operating
Partnership or the Record Holders, or (ii) in its “good faith” or under another express
standard, the General Partner shall act under such express standard and shall not be
subject to any other or different standards imposed by this Agreement or any other
agreement contemplated herein.
In finding that the foregoing provision was not adequate to eliminate the general partner’s fiduciary duty of
loyalty, Vice Chancellor Strine wrote:
This is yet another case in which a general partner of a limited partnership
contends that the partnership agreement eliminates the applicability of default principles
of fiduciary duty, and in which this court finds that the drafters of the agreement did not
make their intent to eliminate such duties sufficiently clear to bar a fiduciary duty claim.
Here, the drafters of the American Real Estate Partners, L.P. partnership agreement did
not clearly restrict the fiduciary duties owed to the partnership by its general partner, a
defendant entity wholly owned by defendant Carl Icahn. Indeed, the agreement seems to
contemplate that the general partner and its directors could be liable for breach of
fiduciary duty to the partnership if they acted in bad faith to advantage themselves at the
expense of the partnership.
***
Once again, therefore, this court faces a situation where an agreement which
does not expressly preclude the application of default principles of fiduciary is argued to
do so by implication. Indeed, this case presents the court with an opportunity to address a
contractual provision similar to the one it interpreted on two occasions in Gotham
Partners, L.P. v. Hallwood Realty Partners, L.P., and contemporaneously with this case
in Gelfman v. Weeden Investors, L.P. In each of those cases, this court held that the
traditional fiduciary entire fairness standard could not be applied because it was
inconsistent with a contractual provision providing a general partner with sole and
complete discretion to effect certain actions subject solely to a contract-specific liability
standard. The court’s decision was based on two factors. First, the court noted the
difference between the sole and complete discretion standard articulated in the
agreements, which explicitly stated that the general partner had no duty to consider the
interests of the partnership or the limited partner in making its decisions, and the
traditional notion that a fiduciary acting in a conflict situation has a duty to prove that it
acted in a procedurally and substantively fair manner. Second, and even more critically,
however, each of the agreements indicated that when the sole and complete discretion
standard applied, any other conflicting standards in the agreements, other contracts, or
under law (including the DRULPA) were to give way if it would interfere with the
general partners’ freedom of action under the sole and complete discretion standard. That
is, in each case, the agreement expressly stated that default principles of fiduciary duty
would be supplanted if they conflicted with the operation of the sole and complete
discretion standard.
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Unlike DRLPA, under Tex. LP Stats., the duties of care and loyalty and the obligation of
good faith may not be eliminated by the partnership agreement, but the statute leaves room for
some modification by contract.419 For example, the partnership agreement may not eliminate the
duty of care but may determine the standards by which the performance of the obligation is to be
measured, if the standards are not “manifestly unreasonable.”420 In one case decided prior to the
passage of the TRPA and the TBOC, the court stated that, when the parties bargain on equal
terms, a fiduciary may contract for the limitation of liability, though public policy would
preclude limitation of liability for self-dealing, bad faith, intentional adverse acts, and reckless
indifference with respect to the interest of the beneficiary.421
With respect to a partner’s duty of loyalty, Tex. LP Stats. provide that the partnership
agreement may not eliminate the duty of loyalty, but may identify specific types or categories of
activities that do not violate the duty of loyalty, again if not “manifestly unreasonable.”422 The
level of specificity required of provisions in the partnership agreement limiting duties pursuant to
Tex. LP Stats. is unknown. In fact, it may depend upon the circumstances, such as the
sophistication and relative bargaining power of the parties, the scope of the activities of the
partnership, etc.
This case presents a twist on Gotham Partners and Gelfman. Like the
provisions in Gotham Partners and Gelfman, section 6.13(d) sets forth a sole discretion
standard that appears to be quite different from the duty of a fiduciary to act with
procedural and substantive fairness in a conflict situation. What is different about
section 6.13(d), however, is that it does not expressly state that default provisions of law
must give way if they hinder the General Partner’s ability to act under the sole discretion
standard. Rather, section 6.13(d) merely states that other standards in the Agreement or
agreements contemplated by the agreement give way to the sole discretion standard. By
its own terms, section 6.13(d) says nothing about default principles of law being
subordinated when the sole discretion standard applies.
***
This court has made clear that it will not be tempted by the piteous pleas of
limited partners who are seeking to escape the consequences of their own decisions to
become investors in a partnership whose general partner has clearly exempted itself from
traditional fiduciary duties. The DRULPA puts investors on notice that fiduciary duties
may be altered by partnership agreements, and therefore that investors should be careful
to read partnership agreements before buying units. In large measure, the DRULPA
reflects the doctrine of caveat emptor, as is fitting given that investors in limited
partnerships have countless other investment opportunities available to them that involve
less risk and/or more legal protection. For example, any investor who wishes to retain
the protection of traditional fiduciary duties can always invest in corporate stock.
But just as investors must use due care, so must the drafter of a partnership
agreement who wishes to supplant the operation of traditional fiduciary duties. In view
of the great freedom afforded to such drafters and the reality that most publicly traded
limited partnerships are governed by agreements drafted exclusively by the original
general partner, it is fair to expect that restrictions on fiduciary duties be set forth clearly
and unambiguously. A topic as important as this should not be addressed coyly.
419
420
421
422
TRLPA §§ 4.03(b), 13.03(a); TRPA § 1.03(b); TBOC §§ 152.002(b); 153.003(a).
TRLPA §§ 4.03(b), 13.03(a); TRPA § 1.03(b); TBOC § 152.002(b)(3).
Grider v. Boston Co., Inc., 773 S.W.2d 338, 343 (Tex. App.—Dallas 1989, writ denied).
TRLPA §§ 4.03(b), 13.03(a); TRPA § 1.03(b)(2); TBOC §§ 152.002(b)(2), 153.003(a).
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Tex. LP Stats. provide that the obligation of good faith may not be eliminated by the
partnership agreement, but the agreement may determine the standards by which the
performance is to be measured if not “manifestly unreasonable.”423 Again the parameters of this
provision are not readily apparent and probably will depend, at least in part, on the circumstances
of any particular case. Texas law requires a limited partnership to keep in its registered office,
and make available to the partners for copying and inspection, certain minimum books and
records of the partnership.424 This mandate provides a statutory mechanism by which a partner
may obtain the documents specified therein, but should not be viewed as in any way limiting a
general partner’s broader fiduciary duty of candor regarding partnership affairs as developed in
case law and as provided in Tex. LP Stats.425
F.
Indemnification
A limited partnership is required to indemnify a general partner who is “wholly
successful on the merits or otherwise” unless indemnification is limited or prohibited by a
written partnership agreement.426 A limited partnership is prohibited from indemnifying a
general partner who is found liable to the limited partners or the partnership or for an improper
personal benefit if the liability arose out of willful or intentional misconduct.427 A limited
partnership is permitted, if provided in a written partnership agreement, to indemnify a general
partner who is determined to meet certain standards. These standards require that the general
partner conducted himself in good faith; and, if the conduct was in an official capacity, then the
general partner reasonably believed the conduct was in the best interest of the partnership, or, in
cases of conduct outside the general partner’s official capacity, that the conduct was not opposed
to the partnership’s best interest; however, in the case of a criminal proceeding, the general
partner must have had no reasonable cause to believe the conduct was unlawful.428 If a general
partner is not liable for willful or intentional misconduct, but is found liable to the limited
partners or partnership for improper benefit, permissible indemnification is limited to reasonable
expenses.429 General partners may only be indemnified to the extent consistent with the
statute.430 Limited partners, employees and agents who are not also general partners may be
indemnified to the same extent as general partners and to such further extent, consistent with
law, as may be provided by the partnership agreement, general or specific action of the general
partner, by contract, or as permitted or required by common law.431 Insurance providing
coverage for unindemnifiable areas is expressly permitted.432
G.
423
424
425
426
427
428
429
430
431
432
Flexibility In Raising Capital
TRLPA §§ 4.03(b), 13.03(a); TRPA § 1.03(b)(4); TBOC §§ 152.002(b)(4), 153.003(a).
TRLPA §§ 1.07; TBOC § 153.551–.552.
See TRPA § 4.03; TBOC §§ 153.551–.552.
TRLPA §§ 11.08, 11.21; TBOC §§ 8.003, 8.051.
TRLPA §§ 11.03, 11.05; TBOC § 8.102(b).
TRLPA § 11.02; TBOC § 8.101(a).
TRLPA §§ 11.03, 11.05; TBOC § 8.102(b).
TRLPA § 11.13; TBOC § 8.004.
TRLPA §§ 11.15, 11.17; TBOC § 8.105.
TRLPA § 11.18; TBOC § 8.151.
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Limitations on liability and more centralized management make the limited partnership a
more suitable entity for raising capital than the general partnership. However, the limited
partnership’s usefulness with respect to raising capital is limited by restrictions on the ability of
owners to deduct passive losses for federal income tax purposes.
Under Tex. LP Stats., contributions to a limited partnership by either a general or a
limited partner may consist of any tangible or intangible benefit to the limited partnership or
other property of any kind or nature, including cash, a promissory note, services performed, a
contract for services to be performed, other interests in or securities of the limited partnership, or
interests or securities of any other limited partnership, domestic or foreign, or other entity.433
However, a conditional contribution obligation, including a contribution payable upon a
discretionary call prior to the time the call occurs, may not be enforced until all conditions have
been satisfied or waived.434
Although a general partner is personally liable for all of the debts and obligations of the
limited partnership,435 if provided in a written partnership agreement, (i) a person may be
admitted as a general partner in a limited partnership, including as the sole general partner, and
acquire a partnership interest in the limited partnership without (x) making a contribution to the
limited partnership or (y) assuming an obligation to make a contribution to the limited
partnership; and (ii) a person may be admitted as a general partner in a limited partnership,
including as the sole general partner, without acquiring a partnership interest in the limited
partnership.436
Absent a contrary provision in the written partnership agreement, profits and losses of a
limited partnership are to be allocated in accordance with the partnership interests reflected in the
records that the partnership is required to maintain under Tex. LP Stats., or in the absence of
such records, in proportion to capital accounts.437 Additionally, absent a different provision in
the written partnership agreement, distributions representing a return of capital are to be made in
accordance with the relative agreed value of capital contributions made by each partner, and
other distributions are made in proportion to the allocation of profits.438
H.
Transferability of Ownership Interests
Unless otherwise provided by the limited partnership agreement, a partnership interest is
assignable in whole or in part and will not require winding up a limited partnership.439 The
assignment of the partnership interest will not, however, entitle the assignee to become, or to
exercise the rights or powers of, a partner unless the partnership agreement provides
otherwise.440 Instead, the assignment will entitle the assignee to an allocation of income, gain,
433
434
435
436
437
438
439
440
TRLPA § 5.01; TBOC § 153.201.
TRLPA § 5.02(d); TBOC § 153.202.
TRLPA §§ 4.01(d), 4.03(b); TBOC § 153.152.
TRLPA § 4.01(c); TBOC § 153.151(c)–(d).
See TRLPA § 5.03; TBOC § 153.206.
See TRLPA § 5.04; TBOC § 153.208.
TRLPA § 7.02; TBOC § 153.251.
TRLPA § 7.02(a)(2); TBOC § 153.251(b)(2).
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loss, deductions, credits or similar items and to receive distributions to which the assignor was
entitled.441 If a general partner assigns all of his or her rights as a general partner, a majority in
interest of the limited partners may terminate the assigning general partner’s status as a general
partner.442 Until an assignee of a partnership interest becomes a partner, the assignee has no
liability as a partner solely by reason of the assignment.443
I.
Continuity of Life
Although a limited partnership does not have an unlimited life to the same extent as a
corporation, the death or withdrawal of a limited partner or the assignment of the limited partner
interest to a third party will not affect the continuity of existence of the limited partnership unless
the partners agree otherwise or unless no limited partners remain.444 A limited partnership is
dissolved under TRLPA, or required to commence winding up under the TBOC, upon the first to
occur of the following events: (i) any event specified in the partnership agreement as causing
dissolution, or the winding up or termination of, the partnership, (ii) all of the partners of the
limited partnership agreeing in writing to dissolve the limited partnership, (iii) an event of
withdrawal of a general partner under Tex. LP Stats. (i.e., death, removal, voluntary withdrawal
and, unless otherwise provided in the partnership agreement, bankruptcy of a general partner)445
absent certain circumstances446 or (iv) a court of competent jurisdiction dissolving the
partnership because (a) the economic purpose of the partnership is likely to be unreasonably
frustrated, (b) a partner has engaged in conduct relating to the partnership that makes it not
reasonably practicable to carry on the business in the partnership with that partner, or (c) it is not
reasonably practicable to carry on the business of the limited partnership in conformity with the
partnership agreement.447
If the limited partnership is terminated or dissolved, the limited partnership’s affairs must
be wound up as soon as reasonably practicable unless it is reconstituted or the partnership
agreement provides otherwise.448 However, upon the withdrawal of a general partner (unless the
limited partnership agreement otherwise provides),449 the limited partnership may continue its
business without being would up if (i) at least one general partner remains and the partnership
441
442
443
444
445
446
447
448
449
TRLPA § 7.02(a)(3); TBOC § 153.251(b)(3).
TRLPA § 7.02(a)(4); TBOC § 153.252(b).
TRLPA § 7.02(b); TBOC § 153.254(a).
TRLPA §§ 8.01, 8.02; TBOC §§ 11.051, 11.058.
TRLPA § 4.02; TBOC § 153.155.
Under TRLPA section 6.02 and TBOC section 153.155(b) a general partner has a right to withdraw which
cannot be eliminated by the partnership agreement, although the partnership may prohibit withdrawal and
violation thereof can result in the general partner being liable for damages. TRLPA section 6.03 and TBOC
section 153.110 provide that a limited partner may withdraw in accordance with the partnership agreement;
previously a limited partner could withdraw on six months notice if the partnership agreement were silent on
limited partner withdrawal. Under TBOC section 11.058(b), as amended in 2007 by H.B. 1737, a winding up
of a limited partnership is not required by the TBOC if the limited partnership agreement provides that
withdrawal of the general partner does not require winding up of the limited partnership.
TRLPA § 8.02; TBOC §§ 11.051, 11.314.
TRLPA § 8.04; TBOC § 11.052.
TRLPA § 8.01(3); TBOC §§ 11.051(4), 11.058(b).
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agreement permits the business of the limited partnership to be carried on by the remaining
general partner or partners or (ii) all (or a lesser percentage stated in the partnership agreement)
remaining partners agree in writing to continue the business of the limited partnership within a
specified period after the occurrence of the dissolution event and agree to the appointment, if
necessary, of one or more new general partners.450
Many existing limited partnership agreements contain provisions defining events of
withdrawal in a manner intended to negate continuity of life for purposes of the Former
Classification Regulations (e.g., certain events of bankruptcy of the general partner). Since these
dissolution provisions are not required under the new Check-the-Box Regulations, consideration
should be given to whether the provisions conform to the business purposes of the partners; if
they do not, the provisions should be amended. The lenders to these limited partnerships, as well
as the lenders’ lawyers, may also have an interest in the wording of the limited partnership
dissolution provisions.
J.
Formation
The cost of forming a limited partnership is usually greater than that of forming a general
partnership. A certificate of formation containing (1) the name of the entity, (2) a statement that
it is a limited partnership, (3) the name and address of each general partner; (4) the address of the
registered office and the name and address of the registered agent for service of process; and (5)
the address of the principal office where books and records are to be kept, must be filed with the
Secretary of State.451 Additionally, a filing fee of $750 must be paid upon filing the certificate of
formation.452
The Tex. LP Stats. contain a number of default provisions that govern the limited
partnership in the absence of any relevant provisions in the partnership agreement. Except as
provided in the Tex. LP Stats., the partners generally have the freedom to contract around these
default provisions and to provide for the rights and obligations of the partners in the partnership
agreement.453 Since the default provisions of the Tex. LP Stats. to an extent reflect the
requirements of the Former Classification Regulations, attorneys drafting limited partnership
agreements should now consider whether the business expectations of the partners require
negation of some of the default provisions, particularly in the context of dissolution.
450
451
452
453
TRLPA § 8.01; TBOC §§ 11.051(4), 11.058(2), 11.152(a), 153.501(b). Under the TRLPA, such agreement
must be made within ninety days; under the TBOC, it must be made within a year. TBOC section 153.501
and Revisor’s Note thereto. The partnership agreement may also provide for continuation of the partnership
after dissolution for reasons in addition to an event of withdrawal in respect of a general partner.
TBOC §§ 3.001, 3.005, 3.011. Limited partnerships formed prior to January 1, 2006 were required to file a
certificate of limited partnership instead, though with substantially similar requirements for the contents. See
TRLPA § 2.01; see also Arkoma Basin Exploration Co. v. FMF Assocs.1990-A, Ltd., 118 S.W.3d 445, 455
(Tex. App.—Dallas 2003, no pet.); Garrett v. Koepke, 569 S.W.2d 568,569 (Tex. Civ. App.—Dallas 1978,
writ ref’d n.r.e.); Brewer v. Tehuacana Venture, Ltd., 737 S.W.2d 349, 352 (Tex. App.—Houston [14th Dist.]
1987, no writ).
TBOC § 4.155(1). The fee is the same as it was under the TRLPA. See TRLPA §§ 2.01(a); 12.01(1).
See TRPA § 1.03; TBOC §§ 152.002, 153.003.
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The Tex. LP Stats. assume the existence of a partnership agreement, but allow the
agreement to be either written or oral. The name of the limited partnership must contain the
word “limited,” the phrase “limited partnership,” or an abbreviation of either.454
Unless the partnership agreement provides otherwise, unanimity is required to amend a
limited partnership agreement.455 Since it may be difficult to get unanimity, it may be
appropriate to provide that amendments may be made with the approval of a simple majority or
supermajority of the partners. If this type of provision is included, it is important to specify
whether the requisite approval is based on sharing ratios, capital account balances, or some other
factor or is merely per capita. Also, even if a majority vote is sufficient for most amendments,
certain amendments (e.g., those that disproportionately affect a particular partner or group of
partners or increases the capital commitment of partners) require a different approval (e.g., the
approval of the affected partner or group of partners (or some percentage of that group of
partners)). If the amendment provisions are purposefully drafted to give less than all of the
partners the right to make amendments that disproportionately affect a particular partner or group
of partners, it may be wise to expressly specify in the partnership agreement, to the extent
permitted by the Tex. LP Stats., the ability of the general partners to act inconsistently with the
fiduciary duties normally required of them.
K.
Operations in Other Jurisdictions
Multistate operations of limited partnerships have been prevalent for a sufficient period
for most states to have limited partnership statutes which contain provisions for the qualification
of foreign limited partnerships to do business as such so that the limited liability of the limited
partners will be recognized under local law.456 To qualify to do business as a foreign limited
partnership in most states, the limited partnership must file with the state’s secretary of state
evidence of its existence and an application that generally includes inter alia information
regarding its jurisdiction and state of organization, its registered office and agent for service of
process in the state (and providing that in the event that there is at any relevant time no duly
designated agent for service of process in the state, then appointing the state’s secretary of state
as agent for service of process), the names and addresses of its general partners, the business it
proposes to pursue in the state and the address of its principal office.
In New York there is now an additional requirement that within 120 days after the filing
of its application for authority, the foreign limited partnership must publish once each week for
six successive weeks in one daily and one weekly newspaper (each being designated by the
county clerk in the county where the partnership is located) generally the same information
required to be filed with the New York Department of State and must file a proof of publication
454
455
456
TBOC § 5.055(a). The TBOC has eliminated the TRLPA limitations on using a limited partner’s name in the
name of the partnership, as well as the requirement that the necessary words or letters designating a limited
partnership be at the end of the entity’s name. See Revisor’s Note to TBOC § 5.055. Under TRLPA § 1.03,
an entity’s name had to contain the words “Limited Partnership,” “Limited,” or the abbreviation “L.P.,”
“LP” or “Ltd.” as the last words or letters of its name.
TRPA § 4.01(i); TBOC § 152.208.
See TRLPA article 9; see generally TBOC title 1, chapter 9.
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with the New York Department of State. Failure to file such proof of publication will result in
automatic suspension of the entity’s right to transact business in New York.457
L.
Business Combinations
Under Texas law, a limited partnership may merge with a corporation, LLC or another
partnership and convert from a limited partnership into another form of entity without effecting a
merger or transfer of assets.458 The Tex. LP Stats. have provisions relating to the mechanics of
adopting a plan of merger or conversion, obtaining owner approval, filing with the Secretary of
State, and protecting creditors.
The Tex. LP Stats. do not contain any analogue to TBCA arts. 5.09 and 5.10 and the
parallel TBOC provisions which require shareholder approval of sales of all or substantially all
of a corporation’s assets in certain circumstances.459 Requirements for limited partner approval
of an asset transaction are left to the limited partnership agreement if the partners wish to provide
such requirements.
V.
LIMITED LIABILITY COMPANY.
A.
General
LLCs formed or converting into a Texas LLC after January 1, 2006, those formed prior to
that date but voluntarily opting in, and all limited liability companies after January 1, 2010 will
be governed by Title 3 and pertinent provisions of Title 1 of the TBOC.460 Older LLCs not
opting in will continue to be governed by the LLC Act until January 1, 2010.461 Because until
2010 some LLCs will be governed by the LLC Act and others by the TBOC and because the
substantive principles under both statutes are generally the same, the term “Tex. LLC Stats.” is
used herein to refer to the TBOC and the LLC Act collectively, and the particular differences
457
458
459
460
461
N.Y. REV. LTD. P’SHIP ACT § 121-902 (McKinney Supp. 2006). N.Y. REV. LTD. P’SHIP ACT § 121-201
(McKinney Supp. 2006) contains similar publication requirements for newly formed domestic limited
partnerships.
TRLPA §§ 2.11, 2.15; TBOC §10.001. In order for a limited partnership to participate in a conversion,
consolidation, or merger, the partnership agreement must authorize such action and the process for its
approval. See TRLPA §§ 2.11(a)(1)–(2), (d)(1)(F), 2.15(a)(1); TBOC § 10.009(f). Therefore, it is
important to include such a provision. Failure to include the provision will mean that, if such a transaction
is desired, the partnership agreement will first need to be amended to permit it. To the extent the merger
also results in amendments to the partnership agreement, the provisions relating to amendments will also
need to be followed, so it would be prudent to coordinate the vote needed for conversions, consolidations,
and mergers with the vote needed for amendments.
See supra notes 193–194 and accompanying text regarding the requirements of TBCA arts. 5.09–.10 and
the parallel TBOC provisions.
TBOC §§ 401.001, 402.003. The TBOC provisions applicable to LLCs may be officially and collectively
referred to as “Texas Limited Liability Company Law.” TBOC § 1.008(e).
The Texas Limited Liability Company Act, as amended, is found at Article 1528n of the LLC Act. The
operational provisions of the LLC Act are modeled after the TBCA, the TMCLA, and TRLPA. Summary
of Business Organizations Bill (HB 278), 28 BULL. OF BUS. L. SEC. OF THE ST. B. OF TEX. 2, 31–41 (June
1991) [hereinafter “1991 Bill Analysis Summary”]; TEX. REV. CIV. STAT. ANN. art. 1302 (Vernon Supp.
2006); TEX. REV. CIV. STAT. ANN. art. 1302 (Vernon 2003 & Supp. 2004); TEX. REV. CIV. STAT. ANN. art.
6132a-1, arts. 1–13 (Vernon Supp. 2006).
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between the LLC Act and the TBOC are referenced as appropriate. Texas was the fourth state to
adopt an LLC statute and now every state has adopted an LLC Act.462
“The allure of the [LLC] is its unique ability to bring together in a single business
organization the best features of all other business forms—properly structured, its owners obtain
both a corporate-styled liability shield and the pass-through tax benefits of a partnership.”463 All
equity holders of an LLC have the limited liability of corporate shareholders even if they
participate in the business of the LLC. Thus the Tex. LLC Stats. contemplate that LLCs will be
organized with features that resemble corresponding features of corporations.
Under the Check-the-Box Regulations, a domestic LLC with two or more Members
typically would be treated for federal income tax purposes as a partnership.464 An LLC is subject
to Texas Margin Tax.465
An underlying premise of the Tex. LLC Stats. is that the LLC is based in large part upon
a contract between its Members, similar to a partnership agreement. As a result, fundamental
principles of freedom of contract imply that the owners of an LLC have maximum freedom to
determine the internal structure and operation of the LLC. Thus the Tex. LLC Stats. would be
classified as “flexible” LLC statutes.466 This freedom of contract, however, could have resulted
in the inadvertent loss of partnership classification for federal income tax purposes under the
Former Classification Regulations.467
The Tex. LLC Stats. in many cases provide “default” provisions468 designed to reflect the
common expectations of persons engaged in business under the Former Classification
Regulations, and to permit those expectations to be met in the event that the LLC’s
organizational documents do not include a provision specifically dealing with an issue. These
default provisions, however, may result in restrictions on the LLC that are not necessary under
the Check-the-Box Regulations and may unnecessarily change the intended business deal.469
Examples of provisions that were often included in an LLC structure because of the Former
Classification Regulations and which are required by neither the Tex. LLC Stats. nor the Checkthe-Box Regulations:
462
463
464
465
466
467
468
469
See Charles W. Murdock, Limited Liability Companies in the Decade of the 1990s: Legislative and Case
Law Developments and Their Implications for the Future, 56 BUS. LAW 499, 502 (2001).
PB Real Estate, Inc. v. DEM Properties, 719 A.2d 73, 74 (Conn. App. Ct. 1998).
See discussion supra Part I. General—C. Federal ‘Check-the-Box’ Regulations.
See discussion supra Part I. General—E. Texas Entity Taxation—3. Margin Tax. The LLC is not subject to
a franchise tax in Delaware or most other states. See Bruce P. Ely & Christopher R. Grissom, State Taxation
of LLCs and LLPs: An Update, 1 BUS. ENTITIES 24 (1999).
See Robert B. Keatinge, New Gang in Town—Limited Liability Companies: An Introduction, BUS. L. TODAY,
Mar./Apr. 1995, at 5.
See Robert F. Gray et al., Corporations, 45 SW.L.J. 1525, 1537 (1992).
See HOUSE COMM. ON BUS. & INDUS., BILL ANALYSIS, Tex. H.B. 1239, 73d Leg., R.S. (1993) at 1 [hereinafter
1993 LLC Bill Analysis].
See William D. Bagley, The IRS Steps Back—Entity Classification Rules are Relaxed, 6 BUS. L. TODAY 41
(1997).
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(i)
limited duration (Texas law now permits an LLC to have a perpetual
duration like a corporation);
(ii)
management by Members rather than Managers;
(iii)
restrictions on assignments of interests beyond what is required by
applicable securities laws and the desires of the parties; and
(iv)
dissolution of the LLC upon the death, expulsion, withdrawal, bankruptcy
or dissolution of a Member.
B.
Taxation
1.
Check the Box Regulations
Domestic LLCs that have two or more Members ordinarily will be classified as
partnerships for federal income tax purposes, unless the LLC makes an election to be classified
as an association taxable as a corporation.470 A single Member LLC will be disregarded as an
entity separate from its owner under the Check-the-Box Regulations unless the LLC elects to be
taxed as a corporation.471
2.
Other Tax Issues Relating to LLCs
(a)
Texas Entity Taxes
An LLC with gross receipts of $150,000 or more was subject to the Texas franchise tax
until January 1, 2007.472 As a result, an LLC was subject to a franchise tax equal to the greater
of (1) 0.25% of its “net taxable capital,” which equals its Members’ contributions and surplus,
and (2) 4.5% of its “net taxable earned surplus.”473 Unless the LLC had more than one Member
but does not have more than 35 members, the “net taxable earned surplus” of an LLC was based
on the entity’s reportable federal taxable income with the compensation of officers and Managers
being added back plus certain other adjustments and with the amount being apportionable to
Texas based on the percentage of the LLC’s gross receipts from Texas sources.474 An LLC with
fewer than 35 Members could eliminate its Texas franchise tax based on “net taxable earned
surplus” with Member compensation, subject to limits on unreasonable compensation.475 Texas
administrative regulations provided that a single Member LLC could not deduct compensation
paid to the Member in computing “net taxable earned surplus.”476 Such an LLC could, however,
deduct compensation paid to officers or managers other than a Member-Manager.
470
471
472
473
474
475
476
Treas. Reg. § 301.7701-3(b)(i) (as amended in 2003).
Treas. Reg. § 301.7701-3(b)(ii).
TEX. TAX CODE ANN. §§ 171.001, 171.002(d) (Vernon 2002 & Supp. 2004).
Id. § 171.002(a).
See Brandon Janes & Steven D. Moore, The New Texas Franchise Tax, TEX. B.J., Nov. 1991, at 1108.
TEX. TAX CODE ANN. § 171.110(a)(1).
34 TEX. ADMIN. CODE § 3.562(f)(2) (2003) (Public Finance, Franchise Tax, Limited Liability Companies).
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Effective for tax years beginning on or after January 1, 2007, the Margin Tax replaces the
Texas franchise tax and is imposed on LLCs.477
In each other state in which an LLC does business it will be necessary to ascertain the
franchise and income tax treatment of foreign LLCs doing business therein. Because most state
income tax regimes are based on the federal adjusted gross income, an LLC treated as a
partnership for federal income tax purposes should be treated as such for state income tax
purposes in the absence of a specific state statute.478
(b)
Flexible Statute
In Revenue Ruling 88-76, a Wyoming LLC was held to lack continuity of life and free
transferability of interest, because the Wyoming LLC statute requires the unanimous vote of all
remaining Members to continue the LLC upon a Dissolution Event, and the consent of all LLC
Members for any transferee of an interest to participate in the management of the LLC or to
become a Member.479 The Wyoming LLC statute was considered a “bullet proof statute”
because an LLC formed thereunder would always lack these two corporate characteristics
important under the Former Classification Regulations.480 By contrast, the Tex. LLC Stats. are
considered “flexible” statutes because they allow the Members to vary the Regulations to allow
greater organizational flexibility (thus, creating the possibility that an LLC organized thereunder
would be taxable as an “association” rather than a partnership under the Former Classification
Regulations).481
(c)
One Member LLC
The Tex. LLC Stats. permit formation of a one-Member LLC, the status of which is now
certain under the Check-the-Box Regulations.482 As previously stated, for federal income tax
purposes, a single Member domestic LLC will be disregarded as an entity separate from its
owner unless it elects to be taxed as a corporation.483 Many state LLC statutes do not authorize
single Member LLCs.484
477
478
479
480
481
482
483
See discussion supra Part I. General—E. Texas Entity Taxation—3. Margin Tax.
David G. Dietze, The Limited Liability Company: Latest Strategy and Developments, 6 No. 1 INSIGHTS: THE
CORPORATE & SECURITIES LAW ADVISOR, Jan. 1992, at 7.
Rev. Rul. 88-76, 1988-2 C.B. 360, obsoleted by Rev. Rul. 98-37, 1998-2 C.B. 133.
Rul. 88-76, 1988-2 C.B. 360, obsoleted by Rev. Rul. 98-37, 1998-2 C.B. 133; WYO. STAT. ANN. §§ 17-15101–17-15-147 (Michie 2003).
LLC ACT art. 3.02(A), 6.01(B); TBOC § 101.052.
Treas. Reg. § 301.7701-2(a), (c)(2) (as amended in 2003).
In I.R.S. Priv. Ltr. Rul. 2001-18023 (Jan. 31, 2001), the issue was the application of Section 1031 of the
IRC (dealing with tax-free like-kind property exchanges) to a transaction in which an individual conveyed
qualifying real property to the sole member of an LLC for the membership interest of a single member
LLC, which is a disregarded business entity for federal tax purposes. The conveyance of the real property
to the taxpayer would be subject to a real estate transfer fee under state law, but the transfer of an
ownership interest in an LLC to the taxpayer would not be subject to the transfer fee. To avoid incurring a
liability for the local real estate transfer fees incident to the transfer of the real property by the LLC, the
taxpayer was proposing to simply acquire the LLC from its single member. The IRS ruled that, because the
LLC is a single member LLC and will, therefore, be disregarded as an entity separate from its owner, the
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(d)
Contributions of Appreciated Property
As a general rule, a transfer of appreciated property in exchange for an interest in an LLC
classified as a partnership will not result in any recognizable gain or loss for the transferor, the
LLC or any other Member of the LLC.485 The tax basis of the transferor in the LLC interest
thereof and of the LLC in the transferred property is the basis the transferor had in the transferred
property at the time of the transfer.486 Under certain circumstances, a Member’s contribution of
property may result in a net reduction in liability487 to that Member in excess of the Member’s
tax basis in the contributed property. In such a situation, the Member will recognize a gain to the
extent of such excess.488 In addition, certain contributions can be treated as “disguised sales” of
all or a portion of the contributed property by the member to the LLC if the member receives
cash or other property (in addition to an LLC interest) in connection with the transfer.
(e)
Self-Employment Tax
Individuals are subject to a self-employment tax on self-employment income.489 The tax
rate aggregates up to 15.3% and consists of (i) a 12.40% social security equivalent tax on selfemployment income up to a 2008 contribution base of $102,000 (adjusted annually for inflation)
plus (ii) a 2.9% Medicare tax on all self-employment income (there is no ceiling).490 An
individual’s wage income is applied against the contribution base.491 Self-employment income
generally means an individual’s net earnings from the individual’s trade or business.492 An
individual’s self-employment income includes his distributive share of the trade or business
income from a partnership of which he is a partner, including an LLC classified as a partnership
for federal income tax purposes, subject to the exception that a limited partner’s distributive
share of income or loss from a limited partnership generally will not be included in his net
income from self employment.493
In 1994, the IRS issued proposed regulations providing that an individual Member’s
share of income from a trade or business of the LLC is subject to self-employment tax (assuming
484
485
486
487
488
489
490
491
492
493
receipt of the ownership of the LLC by the taxpayer is treated as the receipt by the taxpayer of the real
property owned by the LLC. Accordingly, the taxpayer’s receipt of the sole membership interest in the
LLC which owns the real property would be treated as the receipt of real property directly by the taxpayer
for purposes of qualifying the receipt of the real property for non-recognition of gain under Section 1031.
The ruling applies only to the extent the property held by the LLC, at the time it is transferred to the
taxpayer, is property of a like kind to the real property held for use by the taxpayer in his trade or business
or for investment (not like kind property held by the LLC would be taxable to the taxpayer as boot).
See Larry E. Ribstein, The Emergence of the Limited Liability Company, 51 BUS. LAW. 1, 7 (1995).
I.R.C. § 721(a). But see 26 C.F.R. § 1.707-3 (2003) (discussing disguised sales).
I.R.C. §§ 722–23.
I.R.C. § 752.
I.R.C. § 731.
See I.R.C. § 1401; SSA Pub. No. 05-10022 (2008), available at http://www.ssa.gov/pubs/10022.pdf.
I.R.C. § 1041.
Id.
I.R.C. § 1402(a).
I.R.C. § 1402.
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the LLC is treated as a partnership for federal income tax purposes) unless (i) the Member is not
a managing Member and (ii) the entity could have been formed as a limited partnership rather
than an LLC in the same jurisdiction with the Member qualifying as a limited partner.494 Under
such regulations, if the LLC did not have designated Managers with continuing and exclusive
authority to manage the LLC, then all Members would be treated as Managers for this purpose.
On January 13, 1997 the IRS withdrew its 1994 proposed regulation dealing with
employment taxes in the LLC context and proposed new regulations that would apply to all
entities, including LLCs, classified as partnerships under the Check-the-Box Regulations.495 The
IRS said that it was proposing a “functional” approach that would define “limited partner” for
federal tax purposes, irrespective of the state law classification, because of the proliferation of
new business entities such as the LLC as well as the evolution of state limited partnership
statutes.496 Under the proposed regulations:
Generally, an individual will be treated as a limited partner under the
proposed regulations unless the individual (1) has personal liability (as defined in
§ 301.7701-3(b)(2)(ii) of the Procedure and Administration Regulations) for the
debts of or claims against the partnership by reason of being a partner; (2) has
authority to contract on behalf of the partnership under the statute or law pursuant
to which the partnership is organized; or, (3) participates in the partnership’s trade
or business for more than 500 hours during the taxable year. If, however,
substantially all of the activities of a partnership involve the performance of
services in the fields of health, law, engineering, architecture, accounting,
actuarial science, or consulting, any individual who provides services as part of
that trade or business will not be considered a limited partner.497
Until the proposed regulations are effective for an LLC Member, there is a risk that the IRS will
treat any individual Member’s distributive share of the trade or business income of the LLC as
being subject to self-employment tax, even if the Member is not a Manager and would be treated
as a limited partner under the 1997 proposed regulations, based on the IRS position set forth in
Private Letter Ruling 94-32-018, which was issued prior to the proposed regulation. Under both
current law and the 1997 proposed regulations, an LLC Member will be subject to selfemployment tax on guaranteed payments for services, and Members will not be subject to selfemployment tax on distributions if the LLC is treated as an association taxable as a corporation
for Federal tax purposes.
The Taxpayer Relief Act of 1997 prohibited the IRS from issuing any temporary or final
regulations relating to the definition of a limited partner for employment tax purposes that would
be effective before July 1, 1998.498 The legislative history indicates that Congress wants the IRS
to withdraw the controversial proposed regulation discussed above, which would impose a tax on
494
495
496
497
498
See 26 C.F.R. § 1.1402(a)-18, 59 Fed. Reg. 67,253-01 (proposed Dec. 29, 1994).
Prop. 26 C.F.R. § 1.1402(a)-2, 62 Fed. Reg. 1702 (proposed Jan. 13, 1997).
See id.
Id.
H.R. CONF. REP. NO. 105-220, at 765 (1997).
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limited partners.499 A “sense of the Senate” resolution in the Senate amendment expressed
dissatisfaction with the proposed regulation, noting that Congress, not the Treasury or the IRS,
should determine the law governing self-employment income for limited partners.500 Congress
may again consider ways to rationalize the self-employment tax treatment of LLCs, partnerships
and S-corporations.501
C.
Members; Managers
The owners of an LLC are called “Members,”502 and are analogous to shareholders in a
corporation or limited partners of a limited partnership.503 The “Managers” of an LLC are
generally analogous to directors of a corporation and are elected by the Members in the same
manner as corporate directors are elected by shareholders.504 Under the Tex. LLC Stats.,
however, an LLC may be structured so that management shall be by the Members as in the case
of a close corporation or a general partnership,505 and in that case the Members would be
analogous to general partners in a general or limited partnership but without personal liability.506
For an LLC to be taxed as a partnership, it must have at least two Members, although Texas law
would permit an LLC to have only one Member; a single Member LLC is not treated as a
separate entity for federal tax purposes under the Check-the-Box Regulations unless it elects to
be taxed as a corporation (i.e., a single Member LLC may be taxed as a sole proprietorship or
corporation, but not as a partnership).507
Under the Tex. LLC Stats., any “person” may become a Member or Manager.508 Because
of the broad construction given to “person” by the Tex. LLC Stats., any individual, corporation,
partnership, LLC or other person may become a Member or Manager.509 Thus, it is possible to
499
500
501
502
503
504
505
506
507
508
509
Id.
Id. In a letter to the Chairman of the House Ways and Means Committee dated July 6, 1999, the American
Bar Association Tax Section commented on the uncertainty of the law in this area, recommending that the
IRC be amended to provide that the income of an entity taxable as a partnership (including an LLC) that is
attributable to capital is not subject to self-employment tax, but suggested that, if legislation is not
forthcoming, the best immediately available approach is that contained in the 1997 proposed regulations. Paul
A. Sax, ABA Tax Section Suggests Legislative Fix for LLC Self-Help Employment Tax, TAX NOTES TODAY,
July 13, 1999, 1999 TNT 133-23, available at http://www.taxanalysts.com.
See “Options to Improve Tax Compliance and Reform Tax Expenditures” prepared by the Staff of the Joint
Committee on Taxation (January 27, 2005).
LLC ACT art. 4.01; TBOC §§ 1.002(53), 101.101–.102.
1991 Bill Analysis Summary at 41.
See LLC ACT art. 2.13; TBOC § 101.302; 1991 Bill Analysis Summary at 41.
LLC ACT art. 2.12; TBOC §§ 1.002(35), 101.251.
1991 Bill Analysis Summary at 41.
See discussions supra I. C. Federal ‘Check-the-Box’ Tax Regulations—2. Check-the-Box Regulations and V.
Limited Liability Company: B. Taxation—2. Other Tax Issues Relating to LLCs—(c) One Member LLC. In
1993, Article 4.01(A) of the LLC Act was amended to expressly provide that an LLC “may have one or more
members.” Tex. H.B. 1239, 73d Leg., R.S. (1993). See also TBOC § 101.101.
LLC ACT art. 4.01C; TBOC § 101.102(a).
“Person” is defined in LLC ACT article 1.02(4) as follows:
(4) “Person” includes an individual, corporation, business trust, estate, trust, custodian,
trustee, executor, administrator, nominee, partnership, registered limited liability
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have an LLC with a corporation as the sole Manager just as it is possible to have a limited
partnership with a sole corporate general partner.
D.
Purposes and Powers
Under Texas law, an LLC may generally be formed to conduct any lawful business,
subject to limitations of other statutes which regulate particular businesses.510 It has all of the
powers of a Texas corporation or limited partnership, subject to any restrictions imposed by
statute or its governing documents.511
E.
Formation
An LLC is formed when one or more persons file a certificate of formation with the
Texas Secretary of State, along with a $300 filing fee.512 The initial certificate of formation must
contain: (1) the name of the LLC, (2) a statement that it is an LLC, (3) the period of its duration,
unless such duration is perpetual, (4) its purpose, which may be any lawful purpose for which
LLCs may be organized, (5) the address of its initial registered office and the name of its initial
registered agent at that address, (6) if the LLC is to have a Manager or Managers, a statement to
that effect and the names and addresses of the initial Manager or Managers, or if the LLC will
not have Managers, a statement to that effect and the names and addresses of the initial
Members, (7) the name and address of each organizer, (8) specified information if the LLC is to
partnership, limited partnership, association, limited liability company, government,
governmental subdivision, governmental agency, governmental instrumentality, and any
other legal or commercial entity, in its own or representative capacity. Any of the foregoing
entities may be formed under the laws of this state or any jurisdiction.
The definition afforded to “person” in the TBOC comes from the Code Construction Act, which states that
“‘Person’ includes corporation organization, government or governmental subdivision or agency, business
trust, estate, trust, partnership, association, and any other legal entity.” TEX. GOV’T CODE § 311.005(2).
510
LLC ACT article 2.01 provides as follows:
Art. 2.01. PURPOSES. A. A limited liability company formed under this Act may engage in any
lawful business unless a more limited purpose is stated in its articles of organization or regulations.
B. A limited liability company engaging in a business that is subject to regulation by another Texas
statute may be formed under this Act only if it is not prohibited by the other statute. The limited liability
company is subject to all limitations of the other statute.
511
512
LLC Act article 2.01 provides that a limited liability company “may engage in any lawful business.” The
term “business,” as defined in LLC Act art. 1.02.A(6), means every “trade and occupation or profession.”
Based on the foregoing, a limited liability company governed by the LLC Act possibly could not be used for a
nonprofit purpose. However, under the TBOC, an LLC’s purpose “may be stated to be or include any lawful
purpose for [an LLC].” TBOC § 3.005(3). Such broad language would seem to negate the prior profit versus
nonprofit ambiguity. See also TBOC § 2.001 (providing “A domestic entity has any lawful purpose or
purposes, unless otherwise provided by this code.”).
Governing documents, as used here, includes an LLC’s Articles of Organization, Certificate of Formation,
Regulations, or Company Agreement. LLC ACT art. 2.02; see TBOC § 101.402.
TBOC §§ 3.001, 4.152(1), 4.154. Prior to January 1, 2006, an LLC was formed by filing articles of
organization with the Secretary of State, which were similar to a certificate of limited partnership under
TRLPA and articles of incorporation under the TBCA. See LLC ACT arts. 3.01, 9.01.
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be a professional LLC, and (9) any other provisions not inconsistent with law.513 An LLC’s
existence as such begins when the Secretary of State files the certificate of formation, unless it
provides for delayed effectiveness as authorized by the TBOC.514 An LLC may also be formed
pursuant to a plan of conversion or merger, in which case the certificate of formation must be
filed with the certificate of conversion or merger, but need not be filed separately. In such case,
the LLC’s formation takes effect on the effectiveness of the plan.515
The name of an LLC must contain words or an abbreviation to designate the nature of the
entity. The designation may be any of the following: the words “Limited Liability Company,”
“Limited Company,” or an abbreviation of either phrase.516 The name must not be the same as
or deceptively similar to that of any domestic or foreign filing entity authorized to transact
business in Texas.517 Prior to accepting a certificate of formation for filing, the Secretary of
State reviews its LLC, limited partnership and corporation records to determine whether the
LLC’s proposed name is impermissibly close to that of an existing filing entity.518
The Tex. LLC Stats. provide that, except as otherwise provided in an LLC’s certificate of
formation or Company Agreement, the affirmative vote, approval, or consent of all Members is
required to amend its certificate of formation.519 Any such amendment must include a statement
that it was approved in accordance with the proper provisions of governing laws,520 or for entities
governed by the LLC Act, alternately as provided in the articles of organization or Regulations,
along with the date of approval.521
LLC Act section 2.23G provides that if the LLC has not received any capital and has not
otherwise commenced business, the articles of organization may be amended by and the LLC
may be dissolved by (a) a majority of the Managers, if there are no Members, or (b) a majority of
the Members, if there are no Managers. The TBOC does not contain such an express provision,
but simply grants broad leeway for an LLC’s Company Agreement (equivalent to the
“Regulations” under the LLC Act) to govern such matters.522
F.
Company Agreement
Most of the provisions relating to the organization and management of an LLC and the
terms governing its securities are to be contained in the LLC’s Company Agreement, which will
513
TBOC §§ 3.005, 3.010, 3.014.
514
TBOC §§ 4.051, 4.052.
515
TBOC § 3.006(b).
TBOC § 5.056. However, LLCs formed prior to September 1, 1993 in compliance with the laws then in
existence need not change their names to comply with the current provisions. TBOC § 5.056(b).
TBOC § 5.053.
516
517
518
Id.
519
LLC ACT art. 2.23H; TBOC §§ 101.356(d), 101.051–.052. For LLCs that continue to be governed by the
LLC Act, the pertinent documents are referred to as the Articles of Organization and the Regulations.
LLC ACT art. 3.06(3); TBOC § 3.053(4).
LLC ACT art. 3.06(3).
See TBOC §§ 101.051–.052.
520
521
522
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typically contain provisions similar to those in limited partnership agreements and corporate
bylaws.523 A Company Agreement is the same as the document referred to as the “Regulations”
for LLCs still governed by the LLC Act. Under the TBOC, the Company Agreement controls
the majority of LLC governance matters and generally trumps the default TBOC provisions
relating to LLCs.524 For example, the TBOC provides that the Company Agreement or
certificate of formation may only be amended by unanimous member consent,525 but if either
document provides otherwise, such as for amendment by manager consent, then it may be
amended pursuant to its own terms.526 The only statutory provisions not subject to contrary
agreement are enumerated in TBOC section 101.054. While the structure and wording of the
TBOC relating to these matters differs from the source LLC Act, the rule has not substantively
changed.527
Although the Company Agreement will ordinarily contain the capital account and other
financial and tax provisions found in a typical limited partnership agreement,528 the Tex. LLC
Stats. do not require that the Company Agreement ever be approved by the Members or be filed
with the Secretary of State or otherwise made a public record. Nevertheless it may be desirable
for the Members to approve the Company Agreement and agree to be contractually bound
thereby.529 The Members’ express agreement to be contractually bound by the Company
523
524
525
526
527
528
529
LLC ACT art. 2.09A; TBOC § 101.052.
See TBOC § 101.052 and Revisor’s Note thereto.
TBOC §§ 101.053, 101.356(d).
See TBOC §§ 101.052, 101.054.
See Revisor’s Note to TBOC § 101.052; LLC ACT arts. 2.09B, 2.23H. With respect to LLCs that continue to
be governed by the LLC Act, the default provision in LLC Act art. 2.23D provides that the affirmative vote,
approval, or consent of a majority of all the Members is required to approve any merger or interest exchange,
dissolution or any act which would make it impossible to carry on the ordinary business of the LLC. The
LLC Act default provisions would require unanimous approval of the Members to amend the Articles (LLC
ACT art. 2.23H), issue additional membership interests (LLC ACT art. 4.01B-1, as amended by H.B. 1637
effective September 1, 2003) or take action beyond the stated purposes of the LLC (LLC ACT art. 2.02B).
The general default voting provision is in LLC Act art. 2.23C-1, which provides that Members or Managers
may take action at a meeting or without a meeting in any manner permitted by the Articles, the Regulations or
the LLC Act and that, unless otherwise provided by the Articles or the Regulations, an action is effective if it
is taken by (1) an affirmative vote of those persons having not fewer than the minimum number of votes that
would be necessary to take the action at a meeting at which all Members or Managers, as the case may be,
entitled to vote on the action were present and voted; or (2) consent of each Member of the LLC, which may
be established by (a) the Member’s failure to object to the action in a timely manner, if the Member has full
knowledge of the action, (b) consent to the action in writing signed by the Member, or (c) any other means
reasonably evidencing consent. Thus, when drafting the Regulations, it is important to override these
provisions if they do not properly reflect the desires of the parties. Also, Paragraph F of LLC ACT article
2.23 provides, as the default rule, that a majority is defined to be determined on a per-capita basis and not, for
instance, by capital contributions or sharing ratios; since this may or may not be appropriate, it is critical that
the Regulations properly set forth the appropriate standard for determining what constitutes a majority.
It is critical that the Company Agreement accurately reflect the business deal of the parties. Absent a
different provision therein, profits and losses of an LLC are to be allocated, and all distributions, whether a
return of capital or otherwise, are to be made in accordance with the relative agreed value of capital
contributions made by each member reflected in the records that the LLC is required to maintain under the
Tex. LLC Stats. LLC ACT arts. 2.22, 5.01-1, 5.03; TBOC §§ 3.151, 101.203, 101.501.
The agreement to be contractually bound could be through signing the Company Agreement directly or
indirectly through a subscription agreement or power of attorney.
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Agreement should facilitate enforcement thereof and their treatment as a “partnership
agreement” for federal income tax purposes.530 In some other states, the agreement which is
referred to in Texas as the Company Agreement is referred to as “operating agreement” or the
“LLC agreement.”531
G.
Management
The business and affairs of an LLC with Managers are managed under the direction of its
Managers, who can function as a board of directors and may designate officers and other agents
to act on behalf of the LLC.532 A Manager may be an individual, corporation, or other entity,
and it is possible to have an LLC which has a single Manager that is a corporation or other
entity.533 The certification of formation or the Company Agreement, however, may provide that
the management of the business and affairs of the LLC may be reserved to its Members.534 Thus
an LLC could be organized to be run without Managers, as in the case of a close corporation, or
it could be structured so that the day to day operations are run by Managers but Member
approval is required for significant actions as in the case of many joint ventures and closely held
corporations.
The Company Agreement should specify who has the authority to obligate the LLC
contractually or to empower others to do so. It should dictate the way in which the Managers or
Members, whichever is authorized to manage the LLC, are to manage the LLC’s business and
affairs.535 The Tex. LLC Stats. provide that the following are agents of an LLC: (1) any officer
or other agent who is vested with actual or apparent authority; (2) each Manager, to the extent
that management of the LLC is vested in that Manager; and (3) each Member, to the extent that
management of the LLC has been reserved to that Member.536 Texas law also provides that an
act, including the execution of an instrument in the name of the LLC, for the purpose of
apparently carrying on in the usual way the business of the LLC by any of the persons named in
LLC Act section 2.21C or TBOC section 101.254(a) binds the LLC unless (1) the person so
acting lacks authority to act for the LLC and (2) the third party with whom the LLC is dealing is
aware of the actor’s lack of authority.537 Lenders and others dealing with an LLC can determine
with certainty who has authority to bind the LLC by reference to its certificate of formation,
Company Agreement and resolutions, just as in the case of a corporation. In routine business
530
531
532
533
534
535
536
537
Philip M. Kinkaid, Drafting Limited Liability Company Regulations and Articles: Sample Documents,
Address at The University of Texas School of Law Sponsored Conference on Current Issues in Partnerships,
Limited Liability Companies, and Registered Limited Liability Partnerships (Jan. 23–24, 1992).
See, e.g., OHIO REV. CODE ANN. § 1705.01(J) (West 2003) (“operating agreement”); DEL. CODE ANN. tit. 6,
§ 18-101(7) (1999 & Supp. 2005) (“LLC agreement”).
LLC ACT arts. 2.12, 2.21; TBOC §§ 101.251–.253.
LLC ACT arts. 2.12, 1.02(4); TBOC § 101.302; TEX. GOV’T CODE § 311.005(2).
LLC ACT art. 2.12; see TBOC § 101.251.
TBOC § 101.252. Along the same lines, LLC Act section 2.21B provides that all officers, agents,
Managers and Members of an LLC, as among themselves and the LLC, have such authority in the
management of the LLC as may be provided in its Regulations or as may be determined by resolution of
the Managers or, to the extent to which management is reserved to them, the Members.
LLC ACT art. 2.21C; TBOC §§ 1.002(35), (37), 101.254(a).
LLC ACT art. 2.21D; TBOC § 101.254(b).
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transactions where verification of authority is not the norm in transactions involving
corporations, the same principles of apparent authority should apply in the LLC context.
Members and Managers acting on behalf of an LLC should disclose that they are acting
on behalf of the entity and that it is an LLC. Under common law agency principles, an agent can
be personally liable on a contract made for an undisclosed or unnamed principal.538
The Tex. LLC Stats. contain no requirements as to the terms of Managers, but allow the
Company Agreement to provide for specified terms of Managers and annual or other regularly
scheduled meetings of Members539; if the Company Agreement is silent as to the term, the
default provision is retention of the Managers. Tex. LLC Stats. allow any number of classes of
Managers, and contains no requirement that such classes either be equal or nearly equal in
number or be elected in strict rotation at successive annual meetings of Members.540
H.
Fiduciary Duties
The Tex. LLC Stats. do not address specifically whether Manager or Member fiduciary
duties exist or attempt to define them,541 but implicitly recognize that they may exist in statutory
provisions which permit them to be expanded or restricted in the Company Agreement.542 The
duty of Managers in a Manager-managed LLC and Members in a Member-managed LLC to the
LLC is generally assumed to be fiduciary in nature, measured by reference to the fiduciary duties
of corporate directors. By analogy to corporate directors, Managers would have the duties of
obedience, care and loyalty and should have the benefit of the business judgment rule. Much
like a corporate director who, in theory, represents all of the shareholders of the corporation
rather than those who are responsible for his being a director, a Manager should be deemed to
have a fiduciary duty to all of the Members. Whether Members owe a fiduciary duty to the other
Members or the LLC will likely be determined by reference to corporate principles in the
absence of controlling provisions in the Certificate of Formation or Company Agreement.543
538
539
540
541
542
See Water, Waste & Land, Inc. v. Lanham, 955 P.2d 997, 1001 (Colo. 1998).
See TBOC § 101.303.
See LLC ACT art. 2.14; TBOC § 101.307.
See Elizabeth M. McGeever, Hazardous Duty? The Role of the Fiduciary in Noncorporate Structures, 4 BUS.
L. TODAY 51, 53 (Mar.–Apr.1995); Robert R. Keatinge et al., The Limited Liability Company: A Study of the
Emerging Entity, 47 BUS. LAW. 375, 401 (1992) (noting that LLC statutes usually do not specify fiduciary
duties of Members or Managers).
LLC ACT article 2.20B provides that the Regulations may expand or reduce fiduciary duties as follows:
To the extent that at law or in equity, a member, manager, officer, or other person has
duties (including fiduciary duties) and liabilities relating thereto to a limited liability
company or to another member or manager, such duties and liabilities may be expanded
or restricted by provisions in the regulations.
Similarly, TBOC section 101.401 provides:
The company agreement of a limited liability company may expand or restrict any duties,
including fiduciary duties, and related liabilities that a member, manager, officer, or other
person has to the company or to a member or manager of the company.
543
Suntech Processing Systems, L.L.C. v. Sun Communications, Inc., No. 05-99-00213-CV, 2000 WL
1780236, at *6 (Tex. App.—Dallas Dec. 5, 2000, pet. denied) (not designated for publication). In Suntech,
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The Tex. LLC Stats. allow LLC Company Agreements to expand or restrict the duties,
including fiduciary duties, and liabilities of Members, Managers, officers and other persons to
the LLC or to Members or Managers of the LLC.544 This provision of Texas law was designed,
in the same vein as the Delaware Limited Liability Company Act (the “DGLLCA”) from which
it drew inspiration, to allow LLCs the flexibility to address fiduciary duties through contract
principles.545 Although the Tex. LLC Stats., unlike their Delaware counterpart, do not include
544
545
a minority Member of a Texas LLC claimed that the controlling Member owed a fiduciary duty as a matter
of law in connection with the winding up of operations and distribution of assets. Id. at *5. The court
pointed out that the Regulations expressly provided for a duty of loyalty to the LLC rather than between the
Members, and, noting the absence of Texas case law on fiduciary duties of LLC Members and looking to
case law regarding fiduciary duties of shareholders of a closely held corporation, held that there was no
fiduciary relationship between the Members as a matter of law. Id. at *1.
See LLC ACT art. 2.20B; TBOC § 101.401. Prior to the effectiveness of S.B. 555 on September 1, 1997,
LLC Act section 8.12 had incorporated by reference the limitation of liability afforded to corporate
directors under TMCLA 1302-7.06 and thereby allowed the limitation of Manager liability by a provision
in the Articles (now, the Certificate of Formation) to the extent permitted for a director under TMCLA
1302-7.06. S.B. 555 deleted such incorporation by reference of TMCLA 1302-7.06 in favor of the broader
authorization now in LLC Act section 2.20B.
DEL. CODE ANN. tit. 6, § 18-1101(a)–(f) (2007). The Delaware Limited Liability Company Act
aggressively adopts a “contracterian approach” (i.e., the bargains of the parties manifested in LLC
agreements are to be respected and rarely trumped by statute or common law) and does not have any
provision which itself creates or negates Member or Manager fiduciary duties, but instead allows
modification of fiduciary duties by an LLC agreement as follows:
18-1101 CONSTRUCTION AND APPLICATION OF CHAPTER AND
LIMITED LIABILITY COMPANY AGREEMENT.
(a) The rule that statutes in derogation of the common law are to be strictly
construed shall have no application to this chapter.
(b) It is the policy of this chapter to give the maximum effect to the principle of
freedom of contract and to the enforceability of limited liability company agreements.
(c) To the extent that, at law or in equity, a member or manager or other person
has duties (including fiduciary duties) to a limited liability company or to another
member or manager or to another person that is a party to or is otherwise bound by a
limited liability company agreement, the member’s or manager’s or other person’s duties
may be expanded or restricted or eliminated by provisions in the limited liability
company agreement; provided, that the limited liability company agreement may not
eliminate the implied contractual covenant of good faith and fair dealing.
(d) Unless otherwise provided in a limited liability company agreement, a
member or manager or other person shall not be liable to a limited liability company or to
another member or manager or to another person that is a party to or is otherwise bound
by a limited liability company agreement for breach of fiduciary duty for the member’s or
manager’s or other person’s good faith reliance on the provisions of the limited liability
company agreement.
(e) A limited liability company agreement may provide for the limitation or
elimination of any and all liabilities for breach of contract and breach of duties (including
fiduciary duties) of a member, manager or other person to a limited liability company or
to another member or manager or to another person that is a party to or is otherwise
bound by a limited liability company agreement; provided, that a limited liability
company agreement may not limit or eliminate liability for any act or omission that
constitutes a bad faith violation of the implied contractual covenant of good faith and fair
dealing.
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provisions that expressly emphasize the principles of freedom of contract and enforceability of
LLC Company Agreements limiting liability for breach of fiduciary duties, the legislative history
and scope of LLC Act section 2.20B, the precursor to TBOC section 101.401, indicates that there
may be more latitude to exculpate Managers and Members for conduct that would otherwise
breach a fiduciary duty under the Tex. LLC Stats. than under provisions of the TBOC and the
TBCA relating specifically to corporations. Provisions in Company Agreements purporting to
limit fiduciary duties need to be explicit and conspicuous as coyness can lead to
unenforceability.546 A provision which purports to limit fiduciary duties in the LLC context “to
(f) Unless the context otherwise requires, as used herein, the singular shall
include the plural and the plural may refer to only the singular. The use of any gender
shall be applicable to all genders. The captions contained herein are for purposes of
convenience only and shall not control or affect the construction of this chapter.
DLLCA sections 18-1101(a)–(f) are counterparts of, and virtually identical to, sections 17-1101(a)–(f) of
the Delaware Revised Limited Partnership Act. See DEL. CODE ANN. tit. 6, § 17-1101 (2007). Thus,
Delaware cases regarding partner fiduciary duties should be helpful in the LLC context.
See Myron T. Steele, supra note 417, at 25, in which Delaware Supreme Court Chief Justice Steele argues
that parties forming limited liability companies should be free to adopt or reject some or all of the fiduciary
duties recognized at common law, that courts should look to the parties’ agreement and apply a contractual
analysis, rather than analogizing to traditional notions of corporate governance, in LLC fiduciary duty
cases, and that:
Delaware’s Limited Liability Company Act does not specify the duties owed by a
member or manager. It does, however, like the Limited Partnership Act, provide for a
default position “to the extent, at law or in equity” limited liability companies have
“duties (including fiduciary duties).” These duties, in turn, “may be expanded or
restricted or eliminated” in the agreement, provided that the “agreement may not
eliminate the implied contractual covenant of good faith and fair dealing.”
The same issues and considerations that arise in limited partnerships arise in governance
disputes in limited liability companies. There is an assumed default to traditional
corporate governance fiduciary duties where the agreement is silent, or at least not
inconsistent with the common law fiduciary duties. Lack of clarity in the agreements on
this point may confuse the court and cause it to focus improperly when addressing the
conduct complained of in a derivative action or in an action to interpret, apply, or enforce
the terms of the limited liability company agreement. Predictably, but not necessarily
correctly, Delaware courts will gravitate toward a focus on the parties’ status relationship
and not their contractual relationship in the search for a legal and equitable resolution of a
dispute unless the agreement explicitly compels the court to look to its terms and not to
the common law fiduciary gloss.
546
See supra note 417 and accompanying text regarding Chief Justice Steele’s views in respect of fiduciary
duties in the limited partnership context.
Solar Cells, Inc. v. True N. Partners, LLC, No. CIV.A.19477, 2002 WL 749163, at *4 (Del. Ch. Apr. 25,
2002). In Solar Cells, Chancellor Chandler enjoined the merger of an LLC with an affiliate of the
controlling owner on the basis of the Delaware “entire fairness” doctrine notwithstanding an operating
agreement section providing in relevant part as follows:
Solar Cells and [First Solar] acknowledge that the True North Managers have fiduciary
obligations to both [First Solar] and to True North, which fiduciary obligations may,
because of the ability of the True North Managers to control [First Solar] and its business,
create a conflict of interest or a potential conflict of interest for the True North Mangers.
Both [First Solar] and Solar Cells hereby waive any such conflict of interest or potential
conflict of interest and agree that neither True North nor any True North Manager shall
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the maximum extent permitted by the laws in effect at the effective date of this Company
Agreement, as such Agreement may be amended from time to time” probably is not adequate.
While courts may be tempted to find contractual limitations on fiduciary duties
ambiguous in particular situations where it appears that the provision is allowing a fiduciary to
get away with something egregious, they should generally recognize the ability of LLCs to
contractually limit fiduciary duties. In McConnell v. Hunt Sports Enterprises,547 the court stated
that Members (of what was apparently a Member-managed LLC) are generally in a fiduciary
relationship and would ordinarily be prohibited from competing with the LLC. The court,
however, recognized the validity of a provision in the Ohio LLC’s operating agreement (the
equivalent of a Texas LLC’s Company Agreement) providing:
Members may Compete. Members shall not in any way be prohibited from or
restricted in engaging or owning an interest in any other business venture of any
nature, including any venture which might be competitive with the business of the
Company.
The Ohio court in McConnell found that this provision clearly and unambiguously permitted a
Member to compete against the LLC to obtain a hockey franchise sought by the LLC.548 The
court noted the trial court’s finding that the competing Members had not engaged in willful
misconduct, misrepresentation or concealment.549
have any liability to [First Solar] or to Solar Cells with respect to any such conflict of
interest or potential conflict of interest, provided that the True North managers have acted
in a manner which they believe in good faith to be in the best interest of [First Solar].
Chancellor Chandler noted that the above clause purports to limit liability stemming from any conflict of
interest, but that Solar Cells had not requested that the Court impose liability on the individual defendants;
rather it was only seeking to enjoin the proposed merger. Therefore, exculpation for personal liability
would have no bearing on whether the proposed merger was inequitable and should be enjoined. Further,
Chancellor Chandler wrote that “even if waiver of liability for engaging in conflicting interest transactions
is contracted for, that does not mean that there is a waiver of all fiduciary duties [for the above quoted
provision] expressly states that the True North Managers must act in ‘good faith.’”
Noting that the LLC was in financial distress and that the owners had been negotiating unsuccessfully to
develop a mutually acceptable recapitalization, the Chancellor found that the managers appointed by the
controlling owners appeared not to have acted in good faith when they had adopted the challenged plan of
merger by written consent without notice to the minority managers. Chancellor Chandler commented:
The fact that the Operating Agreement permits action by written consent of a majority of
the Managers and permits interested transactions free from personal liability does not
give a fiduciary free reign to approve any transaction he sees fit regardless of the impact
on those to whom he owes a fiduciary duty.
547
548
549
725 N.E.2d 1193 (Ohio App. 1999).
Id. at 1215.
Id. at 1214; but see Dragt v. Dragt/DeTray, LLC, 161 P.3d 473 (Wash. App. 2007) (holding that nonmanaging members of a Washington LLC do not owe fiduciary duties to other members unless fiduciary
duties are imposed under the operating agreement).
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Persons who control Members can be held responsible for fiduciary duty breaches of the
Members.550 A legal claim exists for aiding and abetting a breach of fiduciary duty, whether
arising under statute, contract, common law or otherwise.551
The Tex. LLC Stats., which are based on TBCA article 2.35-1, provide that, unless the
articles, certificate of formation, Regulations, or Company Agreement provides otherwise, a
transaction between an LLC and one or more of its Managers or officers, or between an LLC and
any other LLC or other entity in which one or more of its Managers or officers are Managers,
directors or officers or have a financial interest, shall be valid notwithstanding the fact that the
Manager or officer is present or participates in the meeting of Managers which authorizes the
transaction or the Manager’s votes are counted for such purpose, if any of the following is
satisfied:
(i)
The material facts as to the transaction and interest are disclosed or known to the
governing authority, and the governing authority in good faith authorizes the transaction by the
affirmative vote of a majority of the disinterested Managers or Members (as appropriate) even
though the disinterested Managers or Members are less than a quorum; or
(ii)
The material facts as to the transaction and interest are disclosed or known to the
Members entitled to vote thereon, and the transaction is approved in good faith by a vote of the
Members; or
(iii) The transaction is fair to the LLC as of the time it is authorized, approved or
ratified by the Managers or Members.552
In a joint venture, the duty of a Manager to all Members could be an issue because the
Managers would often have been selected to represent the interests of particular Members. The
issue could be addressed by structuring the LLC to be managed by Members who would then
appoint representatives to act for them on an operating committee which would run the business
in the name of the Members. In such a situation, the Members would likely have fiduciary duties
analogous to partners in a general partnership.553
I.
Indemnification
Under the Tex. LLC Stats., an LLC may indemnify any of its Members, Managers,
officers or other persons subject only to such standards and restrictions, if any, as may be set
forth in the LLC’s certificate of formation or Company Agreement.554 The restrictions on
550
551
552
553
554
See In re USACafes, Inc., 600 A.2d 43, 48 (Del. Ch. 1991); Carson v. Lynch Multimedia Corp., 123 F.
Supp. 2d 1254, 1264 (D. Kan. 2000).
Fitzgerald v. Cantor, No. CIV.A.16297-NC, 1999 WL 182573, at *1 (Del. Ch. Mar. 25, 1999) (holding that
the elements of a claim for aiding and abetting a breach of fiduciary duty are: (1) the existence of a
fiduciary relationship; (2) the fiduciary breached its duty; (3) a defendant, who is not a fiduciary,
knowingly participated in a breach; and (4) damaged to the plaintiff resulted from the concerted action of
the fiduciary and the non-fiduciary.
LLC ACT art. 2.17; TBOC § 101.255.
Id.; see TRPA § 4.04; see also TBOC § 152.204.
LLC ACT art. 2.20A; TBOC § 101.402.
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indemnification applicable to regular corporations are not applicable to LLCs.555 This approach
is similar to the approach taken under Delaware law, but could be subject to public policy
limitations.556 In any event, this change increases the importance of having long form
indemnification because a “to maximum extent permitted by law” provision may encompass
things neither the drafter nor the client foresaw, which could lead courts to read in public policy
limits or find the provision void for vagueness. The indemnification provisions should specify
who is entitled to be indemnified for what and under what circumstances, which requires both
thought and careful drafting.
J.
Capital Contributions
The contribution of a Member may consist of any tangible or intangible benefit to the
LLC or other property of any kind or nature, including a promissory note, services performed, a
contract for services to be performed or other interests in or securities or other obligations of any
other LLC or other entity.557 The Company Agreement ordinarily would contain provisions
relative to capital accounts and the allocation of profits and losses comparable to those in a
limited partnership agreement.
K.
Allocation of Profits and Losses; Distributions
Allocations of profits and losses, and distributions of cash or other assets, of an LLC are
made to the Members in the manner provided by the Company Agreement.558 If the Company
Agreement does not otherwise provide, allocations and distributions are made on the basis of the
agreed value of the contributions made by each Member.559 A Member is not entitled to receive
distributions from an LLC prior to its winding up unless specified in the Company Agreement if
the LLC is governed by the TBOC.560 An LLC may not make a distribution to its Members to
the extent that, immediately after giving effect to the distribution, all liabilities of the LLC, other
than liabilities to Members with respect to their interests and non-recourse liabilities, exceed the
fair value of the LLC assets.561 A Member who receives a distribution that is not permitted
555
556
557
558
559
560
561
See generally Chapter 8 of the TBOC, specifically § 8.002(a).
Cf. DEL. CODE ANN. tit. 6, § 18-108 (1999 & Supp. 2002) (providing that an LLC may, and shall have the
power to, indemnify and hold harmless Members, Managers, and other persons from and against any and
all claims).
LLC ACT art. 5.01; TBOC § 1.002(9). LLC Act section 5.02 and TBOC sections 101.052 and 101.151
provide that written obligations to make contributions are enforceable, except to the extent otherwise provided
in the Articles or Regulations (or Certificate of Formation or Company Agreement, as appropriate,) and LLC
Act section 4.07 and TBOC section 101.111(b) provide that an obligation to make a contribution will survive
the assignment of the membership interest. LLC Act section 5.02 and TBOC section 101.156 provide that a
conditional obligation to make a contribution to an LLC, which includes contributions payable upon a
discretionary call prior to the time the call occurs, must be in writing and signed by the Member, and may not
be enforced unless the conditions of the obligation have been satisfied or waived.
LLC ACT arts. 5.02-1, 5.03; TBOC §§ 101.052, 101.201.
LLC ACT arts. 5.02-1, 5.03; TBOC §§ 101.052, 101.201.
TBOC section 101.204 provides this as a new default rule, subject to contrary agreement under section
101.052. The older LLC Act, however, simply provides that Members are entitled to pre-winding up
distributions in accordance with the Articles of Incorporation. LLC Act art. 5.04.
LLC ACT art. 5.09A; TBOC § 101.206.
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under the preceding sentence has no liability to return the distribution under the LLC Act unless
the Member knew that the distribution was prohibited.562
L.
Owner Limited Liability Issues
The Tex. LLC Stats. provide that, except as provided in the Company Agreement, a
Member or Manager is not liable to third parties for the debts, obligations or liabilities of an
LLC, although Members are liable for the amount of any contributions they agreed in writing to
make.563 Members may participate in the management of the LLC without forfeiting this
liability shield, but may be liable for their own torts.564 Because the LLC Act deals expressly
with the liability of Members and Managers for LLC obligations, the principles of “piercing the
562
563
LLC ACT art. 5.09B; TBOC § 101.206(d).
LLC ACT arts. 4.03, 5.02A; TBOC §§ 101.114; 101.151. LLC Act section 4.03 provides as follows:
Art. 4.03. LIABILITY TO THIRD PARTIES. A. Except as and to the extent the regulations
specifically provide otherwise, a member or manager is not liable for the debts, obligations or liabilities of a
limited liability company including under a judgment, decree, or order of a court.
B. Transaction of business outside state. It is the intention of the legislature by the enactment of this
Act that the legal existence of limited liability companies formed under this Act be recognized beyond the
limits of this state and that, subject to any reasonable registration requirements, any such limited liability
company transacting business outside this state be granted the protection of full faith and credit under Section
1 of Article IV of the Constitution of the United States.
C. Parties to actions. A member of a limited liability company is not a proper party to proceedings
by or against a limited liability company, except where the object is to enforce a member’s right against or
liability to the limited liability company.
TBOC Section 101.114 provides for substantially the same protection of Members and Managers as LLC Act
Section 4.03A. See Part “VII. Extraterritorial Recognition of LLC and LLP Limited Liability” regarding
uncertainties as to the extent to which this statutory limitation of liability will be recognized in other states.
The legislative history of the LLC Act mirrors the clear statutory statement that members and managers of an
LLC are not to be personally liable for the obligations of the LLC (whether arising in tort or contract) by
virtue of being a member or manager:
Article 4.03. Liability to Third Parties. This Article provides except as provided
in the regulations, that a member or manager is not liable to third parties, expresses the
legislative intent that limited liability be recognized in other jurisdictions and states a
member is not a proper party to a proceeding by or against a Limited Liability Company.
The clear and unequivocal limitation of personal liability wording of LLC Act section 4.03A is to be
contrasted with the more complicated and narrow wording of TBCA article 2.21, which evolved as the
Legislature attempted to drive a stake through the heart of Castleberry v. Branscum, 721 S.W.2d 270 (Tex.
1986) and its progeny. If the Bar Committee or the Legislature had conceived that the case law which had
evolved in the corporate context would be applicable to LLCs, the wording of the LLC Act would have been
different and might have mirrored that of the TBCA. Intending that corporate veil piercing principles not be
applicable to LLCs, the Bar Committee and the Legislature opted for a simple, expansive and unequivocal
statement that members and managers of LLCs do not have liability for any LLC obligations.
564
The LLC Act does not contain any provision comparable to TRLPA section 3.03 or TBOC section 153.102,
which make a limited partner liable for partnership obligations under certain circumstances if “the limited
partner participates in the control of the business.” See Weber v. U.S. Sterling Securities, Inc., 924 A.2d 816
(Conn. 2007) (holding that liability protection of managers and members under Delaware LLC statute does
not protect members or managers from direct liability for their own torts).
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corporate veil” should not apply to LLCs in Texas, although this issue is not settled.565 Some
state LLC statutes expressly deal with the veil piercing issue by providing that the LLC veil will
565
Two Texas cases have suggested that piercing the veil concepts from corporation law are applicable to LLCs.
McCarthy v. Wani Venture, A.S., ___ S.W.3d ___, 2007 WL 1845088 (Tex. App.–Houston [12th Dist] 2007)
(holding that corporate veil piercing principles apply to Texas LLCs notwithstanding the wording of LLC Act
art. 4.03(a) that “[e]xcept and to the extent the regulations specifically provide otherwise, a member or
manager is not liable for the debts, obligations or liabilities of a limited liability company, including under a
judgment, decree, or order of a court”); Pinebrook Props., Ltd. v. Brookhaven Lake Prop. Owners Ass’n, 77
S.W.3d 487, 500 (Tex. App.—Texarkana 2002, pet. denied) (Texarkana Court of Appeals assumed that
corporate veil piercing rules must be applicable to an LLC because the LLC is a limited liability entity, citing
Castleberry v. Branscum, supra note 239, 721 S.W.2d at 272 [holding that alter ego is a basis for disregarding
the corporate fiction] even though Castleberry was decided five years before the LLC Act was passed and
made no reference to the LLC or any entity other than a business corporation; after analyzing the facts before
it under Castleberry—which has been repudiated by the legislature in amendments to TBCA art. 2.21A, and
under TBCA art. 2.21A, which applies only to corporations and does not apply to LLCs, the court held that
veil piercing was not appropriate in the case sub judice).
The Tex. LLC Stats. do not generally incorporate general corporate law or principles for situations not
addressed in the Tex. LLC Stats. See LLC ACT article 8.12 (Applicability of Other Statutes) for reference to
the few provisions of the TBCA and the TMCLA which apply to LLCs. None of those provisions relates to
piercing the corporate veil. The provisions referenced in LLC Act article 8.12 were expressly incorporated
into the TBOC, but still without reference to piercing the corporate veil.
Even if corporate veil piercing theories were not applicable in Texas, parties dealing with an LLC are not
without remedies against those responsible for the actions of the entity in appropriate situations. In contract
situations, persons dealing with an LLC can condition their doing business with the LLC on (i) the LLC
including in its Company Agreement provisions for the personal liability of members or managers in specified
circumstances or (ii) members or managers personally guaranteeing obligations of the LLC. In the tort
context, a member or manager individually may be a direct tortfeasor and liable under traditional tort law
theories for his own conduct. See Walker v. Anderson, 232 S.W.3d 899 (Tex. App.—Dallas 2007);
Shapolsky v. Brewton, 56 S.W.3d 120, 133 (Tex. App.—Houston [14th Dist.] 2001, pet. denied). Thus, the
LLC shield would be effective as to vicarious torts arising out of LLC activities, but not against a member’s
own miscreant conduct. For example, in a negligence action, the complaint would be against the member qua
actor for his own negligent acts rather than qua member for the LLC’s acts. See Murdock, supra note 462, at
504. A complaint could state a cause of action against a member for his individual negligence qua actor, but
could not state a cause of action against a member for negligence attributed to the LLC due to the act of
someone else.
There have been a number of cases in other jurisdictions in which courts have applied corporate veil piercing
theories to LLCs. See, e.g., N. Tankers (Cyprus) Ltd. v. Backstrom, 967 F. Supp. 1391, 1402 (D. Conn.
1997); Hollowell v. Orleans Reg’l. Hosp., No. CIV.A.95-4029, 1998 WL 283298, at *9 (E.D. La. May 29,
1998); In re Multimedia Commc’n Group Wireless Assoc., 212 B.R. 1006 (Bankr. M.D. Fla. 1997); Marina,
LLC v. Burton, No. CA 97-1013, 1998 WL 240364, at *7 (Ark. App. May 6, 1998); Ditty v. CheckRite, Ltd.,
973 F. Supp. 1320, 1336 (D. Utah 1997). In Ditty, a case examining a Utah limitation of Member liability
statute similar to LLC Act Article 4.03, the court wrote: “While there is little case law discussing veil piercing
theories outside the corporate context, most commentators assume that the doctrine applies to limited liability
companies.” Ditty, 973 F. Supp. at 1336. The court then proceeded to uphold the limited liability of the sole
Member, officer and director for the LLC, noting that the fact that defendant “played an active role in the
firm’s business is, at best, only marginally probative of the factors considered when determining whether to
pierce the corporate veil.” Id. In the court’s view, the significant factors in determining whether to pierce the
entity are “undercapitalization of a close corporation; failure to observe corporate formalities; siphoning of
corporate funds by the dominant shareholder; nonfunctioning of other officers and directors; and the use of the
corporation as a facade for operations of the dominant shareholder.” Id. Texas has its own body of precedent
in the corporate context with respect to piercing the corporate veil and, if a Texas court were to determine to
look to corporate precedent in determining whether to respect the limitation of liability provided by the LLC
Act, would not necessarily consider the same factors as the courts in the reported cases from other
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be pierced to the same extent as the corporate veil566 or that the Members will have the same
liabilities as corporate shareholders.567
M.
Nature and Classes of Membership Interests
A membership interest in an LLC is personal property.568 It does not confer upon the
Member any interest in specific LLC property.569 A membership interest may be evidenced by a
certificate if the Company Agreement so provides.570
The Company Agreement may establish classes of Members having expressed relative
rights, powers and duties, including voting rights, and may establish requirements regarding the
voting procedures and requirements for any actions including the election of Managers and
amendment of the Certificate of Formation and Company Agreement.571 The Company
Agreement could provide for different classes of Members, each authorized to elect a specified
number or percentage of the Managers.572 The Tex. LLC Stats. generally allow even more
flexibility in structuring classes of Members than is available under Texas law in structuring
classes of corporate stock.573
Whether an LLC membership interest is considered a “security” for the purposes of the
Securities Act of 1933, as amended, and state securities or blue sky laws turns on the rights of
the Members as set forth in the Company Agreement and other governing documents and the
ability of the investor to exercise meaningful control over his investment.574 The offer and sale of
566
567
568
569
570
571
572
573
574
jurisdictions. See generally Miller, Cases Involving Limited Liability Companies and Registered Limited
Liability Partnerships, PUBOGRAM (American Bar Association Section of Business Law Committee on
Partnerships and Unincorporated Business Organizations), Vol. XXIV, No. 3, at 19; Ribstein, The Emergence
of the Limited Liability Company, 51 BUS. LAW. 1, 8–9 (Nov. 1995).
See COLO. REV. STAT. 7-80-107 (1998); MINN. STAT. ANN. 322B.303.2 (1995 & Supp. 1998); N.D. CENT.
CODE §§ 10-32-29.3, 44-22-09 (2001); WASH. REV. CODE. ANN. § 25.15.060 (West Supp. 2003).
See W. VA. CODE § 31-B-3-303(b) (2003).
LLC ACT art. 4.04; TBOC § 101.106.
Id.
LLC ACT art. 4.05B; TBOC § 3.201(e).
LLC ACT art. 4.02; TBOC § 101.104.
See LLC ACT art. 2.13; TBOC § 101.104.
See 1993 LLC Bill Analysis at 2; see also TBOC §§ 21.152, 101.104.
The Securities Act of 1933, 15 U.S.C.A. 77a, et seq. (1997) (the “1933 Act”), in § 77b(a)(1) defines the term
“security” to include:
any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness,
certificate of interest or participation in any profit-sharing agreement, collateral-trust
certificate, preorganization certificate or subscription, transferable share, investment
contract, voting-trust certificate, certificate of deposit for a security, fractional undivided
interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any
security, certificate of deposit, or group or index of securities (including any interest therein
or based on the value thereof), or any put, call, straddle, option, or privilege entered into on
a national securities exchange relating to foreign currency, or, in general, any interest or
instrument commonly known as a “security,” or any certificate of interest or participation
in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to
subscribe to or purchase, any of the foregoing.
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As a result of judicial construction of the term “investment contract” this definition now encompasses most
long-term means for raising funds. See Carl W. Schneider, The Elusive Definitions of a “Security”, 14 REV.
SEC. REG. 981, 981 (1981); Carl W. Schneider, Developments in Defining a “Security”, 16 REV. SEC. REG.
985 (1983). The United States Supreme Court has held that the test for determining whether an “investment
contract” exists is “whether the scheme involves an investment of money in a common enterprise with profits
to come solely from the efforts of others.” SEC v. W. J. Howey Co., 328 U.S. 293, 301 (1946); see Robinson
v. Glynn, 349 F.3d 166 (4th Cir. 2003). In Robinson, the Fourth Circuit wrote:
Since Howey, however, the Supreme Court has endorsed relaxation of the requirement that
an investor rely only on others’ efforts, by omitting the word “solely” from its restatements
of the Howey test. And neither our court nor our sister circuits have required that an
investor like Robinson expect profits “solely” from the efforts of others. Requiring
investors to rely wholly on the efforts of others would exclude from the protection of the
securities laws any agreement that involved even slight efforts from investors themselves.
It would also exclude any agreement that offered investors control in theory, but denied it to
them in fact. Agreements do not annul the securities laws by retaining nominal powers for
investors unable to exercise them.
What matters more than the form of an investment scheme is the “economic reality” that
it represents. The question is whether an investor, as a result of the investment agreement
itself or the factual circumstances that surround it, is left unable to exercise meaningful
control over his investment. Elevating substance over form in this way ensures that the
term “investment contract” embodies “a flexible rather than a static principle, one that is
capable of adaptation to meet the countless and variable schemes devised by those who
seek the use of the money of others on the promise of profits.”
Id. at 170. By analogy to corporate stock and investment contracts, a membership interest in an LLC which is
governed by Managers is most likely to be considered to be a security. By analogy to interests in a general
partnership, however, where the LLC is managed by its Members, the membership interest may not be
deemed a security:
A general partnership interest normally is not a security, even if the investor elects to
remain passive. But a general partnership interest may be a security if the rights of a
partner are very limited in substance, or if the partner is an unsophisticated investor who
must rely in fact on the business acumen of some other person.
A limited partnership interest normally is a security. On unusual facts, however, a limited
partnership might not be a security—e.g., where there is a single limited partner who
negotiates directly with the general partner and retains significant influence over the
venture, or where the limited partner otherwise has an active role in the venture.
Carl W. Schneider, The Elusive Definition of a ‘Security’—1990 Update, 24 REV. SEC. & COM. REG. 13, 22
(Jan. 23, 1991); see also Marc I. Steinberg & Karen L. Conway, The Limited Liability Company As A
Security, 19 PEPP. L. REV. 1105 (1992). Steinberg and Conway concluded that:.
While each LLC interest must be analyzed by looking at the applicable statutes as well as
the specific provisions contained in the member agreement and other operating documents,
this article takes the position that LLC interests normally are securities. Three different
methods of analysis lead to this result. First, one may look at the traditional “investment
contract” test and find that LLC interests satisfy the Howey test, especially in light of the
Williamson rationale. Second, LLC interests meet the attributes of stock test as set forth by
the Supreme Court. Finally, one can classify an interest in a LLC as “any interest
commonly known as a security.
Id. at 1122. See also SEC v. Parkersburg Wireless, LLC, 991 F.Supp. 6, 8 (D.D.C. 1997) (holding that
interests in an LLC with 700 Members were investment contracts); S.E.C. v. Vision Communications, Inc.,
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an interest must either be registered under applicable federal and state securities laws575 or
effected in a private576 or other transaction structured to be exempt from those requirements.577
CIV. No. 94-0615, 1944 WL 855061, at *1 (D.D.C. May 11, 1994) (holding LLC interests are securities);
Mark A. Sargent, Will Limited Liability Companies Punch a Hole in the Blue Sky?, 21 SEC. REG. L.J. 429
(1994).
The federal definition of “security” has served as a model for most modern state statutes. JOSEPH C. LONG,
1985 BLUE SKY LAW HANDBOOK § 2.01 (1988 revision).
575
576
Section 5 of the 1933 Act provides that a registration statement must be in effect as to a non-exempt security
before any means of transportation or communication in interstate commerce or of the mails may be used for
the purpose of sale or delivery of such non-exempt security. The primary purpose of the 1933 Act is to
provide a full disclosure of material information concerning public offerings of securities to investors. Ernst
& Ernst v. Hochfelder, 425 U.S. 185, 195 (1976). The registration statement is the primary means for
satisfying the full disclosure requirement. The 1933 Act (particularly §§ 5–7 and Schedule A) and
Regulations C and S-K thereunder contain the general registration requirements. The Securities and
Exchange Commission (“SEC”) has set forth a number of registration forms to be used under varying
circumstances. Form S-1 is the basic form to be used by an issuer unless another form is specifically
prescribed. There are basically three stages in the registration process: the pre-filing stage, the waiting period,
and the post-effective stage. During the pre-filing stage, § 5(c) of the 1933 Act prohibits the use of interstate
facilities (including telephones) or the mails to “offer to sell.” Further, § 5(a) prohibits sales or deliveries at
any time before the “effective” date of the registration statement, which includes the pre-filing stage. The
term sale is defined to include “every contract of sale or disposition of a security or interest in a security, for
value.” During the waiting period, written offers are still prohibited, but oral offers are permitted. Since the
registration statement is still not “effective,” sales or deliveries are still forbidden. During the post-effective
stage, sales may be made freely. A prospectus satisfying the requirements under the 1933 Act must
accompany any interstate or mailed “delivery” of the security if the prospectus has not preceded the delivery.
See generally, LOUIS LOSS, FUNDAMENTALS OF SECURITIES REGULATION ch. 2B (1988). Unlike the federal
statute that seeks full disclosure, many of the state “blue sky” acts are based on a concept known as “merit
regulation.” Id. at chs. 1B, 1C. Under these systems, the state securities administrator can prohibit a
particular security from being offered in that state if the administrator determines that the terms of the offering
are not “fair, just and equitable.” Most state acts do not define “fair, just and equitable.” In the Blue Sky
Cases, the United States Supreme Court validated a number of state acts regulating securities on the basis that
the acts neither violated the Fourteenth Amendment nor unduly burdened interstate commerce. See Hall v.
Geiger-Jones Co., 242 U.S. 539 (1917); Caldwell v. Sioux Falls Stock Yards Co., 242 U.S. 559 (1917);
Merrick v. N.W. Halsey & Co., 242 U.S. 568 (1917).
Section 4(2) of the 1933 Act exempts from the registration requirements of the 1933 Act “transactions by an
issuer not involving any public offering”—generally referred to as “private placements.” The U.S. Supreme
Court has held that the § 4(2) exemption must be interpreted in light of the statutory purpose of the 1933 Act
to “protect investors by promoting full disclosure of information thought necessary to informed investment
decisions” and that its applicability “should turn on whether the particular class affected needs the protection
of the Act.” S.E.C. v. Ralston Purina Co., 346 U.S. 119, 124–25 (1953). Subsequent court opinions have
enumerated a number of more specific factors to be considered in determining whether a transaction involves
a “public offering,” including the following:
(a) the number of offerees (there is no number of offerees that always makes an offering either
private or public; 25 to 35 is generally considered consistent with a private offering, but the
sophistication of the offerees is more important; an offer to a single unqualified investor can defeat
the exemption and an offering to a few hundred institutional investors can be exempt; note that the
judicial focus is upon the number of persons to whom the securities are offered, not the number of
actual purchasers);
(b) offeree qualification (each offeree should be sophisticated and able to bear the economic risk of
the investment; a close personal, family or employment relationship should also qualify an offeree);
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Prior to September 1, 1995, an LLC membership interest represented by a certificate
would ordinarily have been considered a “security” for the purposes of Chapter 8 of the Texas
(c) manner of offering (the offer should be communicated directly to the prospective investors
without the use of public advertising or solicitation);
(d) availability of information (each investor should be provided or otherwise have access to
information comparable to that contained in a registration statement filed under the 1933 Act;
commonly investors are furnished a “private offering memorandum” describing the issuer and the
proposed transaction in at least as much detail as would be found in a registration statement filed
with the SEC for a public offering registered under the 1933 Act); and
(e) absence of redistribution (the securities must come to rest in the hands of qualified purchasers and
not be redistributed to the public; securities sold in a private placement generally may be replaced
privately, freely sold by a person who is not an affiliate of the issuer in limited quantities to the
public pursuant to SEC Rule 144, 17 C.F.R. 230.144 (2008), after a one-year holding period (if the
issuer files reports with the SEC, the securities may be sold in limited quantities to the public
pursuant to Rule 144 after a six-months holding period), or sold to the public pursuant to a
registration statement filed and effective under the 1933 Act; the documentation of a private
placement normally includes contractual restrictions on subsequent transfers of the securities
purchased).
See 1933 Act Release No. 33-8869 (December 6, 2007); Doran v. Petroleum Mgmt. Corp., 545 F.2d 893, 900
(5th Cir. 1977); Carl W. Schneider, The Statutory Law of Private Placements, 14 REV. SEC. REG. 869, 870
(1981); ABA Comm. on Fed. Regulation of Sec., Integration of Securities Offerings: Report of the Task
Force on Integration, 41 BUS. LAW. 595, 595 (1986); C. Edward Fletcher, III, Sophisticated Investors Under
the Federal Securities Laws, 1988 DUKE L. J. 1081, 1120–24 (1988).
SEC Regulation D (“Reg D”), 17 C.F.R. 230.501–.506 (2007), became effective April 15, 1982 and is now
the controlling SEC regulation for determining whether an offering of securities is exempt from registration
under § 4(2) of the 1933 Act. Under Rule 506 of Reg D, there is no limitation on the dollar amount of
securities that may be offered and sold, and the offering can be sold to an unlimited number of “accredited
investors” (generally institutions, individuals with a net worth of over $1 million and officers and directors
and general partners of the issuer) and to a maximum of thirty-five nonaccredited investors (there is no limit
on the number of offerees so long as there is no general advertising or solicitation). Each of the purchasers, if
not an accredited investor, must (either alone or through a representative) have such knowledge and
experience in financial matters as to be capable of evaluating the risks and merits of the proposed investment.
Unless the offering is made solely to accredited investors, purchasers must generally be furnished with the
same level of information that would be contained in a registration statement under the 1933 Act. Resales of
the securities must be restricted and a Form D notice of sale must be filed with the SEC. An offering which
strictly conforms to the Reg D requirements will be exempt even if it does not satisfy all of the judicial criteria
discussed above; however, since Reg D does not purport to be the exclusive means of compliance with § 4(2),
a placement which conforms to the foregoing judicial standards also will be exempt from registration under §
4(2) of the 1933 Act, even if it does not strictly conform to Reg D.
577
Section 3(a)(11) of the 1933 Act exempts from the registration requirements of the 1933 Act “any security
which is a part of an issue offered and sold only to persons resident within a single State or Territory, where
the issuer of such security is a person resident and doing business within, or if a corporation, incorporated by
and doing business within, such State or Territory.” Consequently there are two principal conditions to the
intrastate offering exemption: (a) that the entire issue of securities be offered and sold exclusively to, and
come to rest in the hands of, residents of the state in question (an offer or sale to a single non-resident will
render the exemption unavailable to the entire issue); and (b) the issuer be organized under the laws of and
doing substantial business in the state. Rule 147 promulgated under the 1933 Act articulates specific
standards for determining whether an offering is intrastate within the meaning of Section 3(a)(11).
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Business and Commerce Code as in effect prior to that date (“Pre 9/1/95 B&CC”).578 Such an
interest would ordinarily have been considered a “certificated security” under Pre 9/1/95 B&CC
section 8.102 because it would have been (a) represented by an instrument issued in bearer or
registered form; (b) of a type dealt in as a medium for investment; and (c) a class or series of
shares, participations, interests or obligations. Under Pre 9/1/95 B&CC, security interests in
certificated LLC interests would have been perfected by possession, as in the case of corporate
shares.579 Security interests in membership interests which were not evidenced by an instrument
would have been perfected by a financing statement filing under Pre 9/1/95 B&CC section 9.580
As of September 1, 1995, LLC membership interests are not “securities” governed by
Chapter 8 of the Texas Business & Commerce Code, as amended by House Bill 3200 (“H.B.
3200” and “Post 9/1/95 B&CC”), unless the interests are dealt in or traded on securities
exchanges or markets or unless the parties expressly agree to treat them as such.581 Under Post
9/1/95 B&CC Chapter 9, LLC membership interests should be classified as “general
intangibles,” whether or not represented by a certificate, and security interests would be
perfected by a financing statement filing.582
Under the Tex. LLC Stats., a judgment creditor of a Member may on application to a
court of competent jurisdiction secure a “charging order” against the Member’s membership
interest.583 In a “charging order” a court “charges” the membership interest such that any
distributions thereon are made as directed by the court, but does not order foreclosure of the
interest or compel any distributions. A charging order should not permit a judgment creditor of a
Member to receive distributions on an interest subject to a prior perfected security interest.
N.
578
579
580
581
582
583
Assignment of Membership Interests
Act of June 17, 1983, 68th Leg., R.S., ch. 442, § 1, 1983 Tex. Gen. Laws 2511, amended by Act of June 16,
1995, 74th Leg., R.S., ch. 962, § 1, sec. 8.102, 1995 Tex. Gen. Laws 4760, 4761.
Pre 9/1/95 B&CC § 8.321.
A membership interest not represented by an instrument would be a “general intangible” under Pre 9/1/95
B&CC section 9.106. A security interest therein would attach as provided in Pre 9/1/95 B&CC section 9.203
when the debtor has signed a proper security agreement, value has been given and the debtor has rights
therein, and would be perfected by a financing statement filing under Pre 9/1/95 B&CC section 9.302.
Post 9/1/95 B&CC §§ 8.102, 8.103(c).
Post 9/1/95 B&CC §§ 9.106, 9.302(a). An LLC membership interest held in a securities account at a broker
or dealer would be a “financial asset” and a “security entitlement” under Post 9/1/95 B&CC
sections 8.102(a)(17), 8.103(c) and 8.501(b)(1), and a security interest therein could be perfected by “control”
or by filing under Post 9/1/95 B&CC sections 9.106 and 9.115.
LLC Act article 4.06A, as amended in 2007 by H.B. 1737, provides:
On application by a judgment creditor of a member or of any other owner of a membership
interest, the court may charge the membership interest of the judgment debtor to satisfy the
judgment. To the extent that the membership interest is charged in this manner, the
judgment creditor has only the right to receive any distribution to which the judgment
debtor would otherwise have been entitled in respect of the membership interest.
See LLC ACT art. 7.03. TBOC § 101.112 provides substantially the same.
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Unless otherwise provided in an LLC’s Company Agreement, a Member’s interest in an
LLC is assignable in whole or in part.584 An assignment of a membership interest does not of
itself dissolve the LLC or entitle the assignee to participate in the management and affairs of the
LLC or to become, or to exercise any of the rights of, a Member.585 An assignment entitles the
assignee to be allocated income, gain, loss, deduction, credit or similar items, and receive
distributions, to which the assignor was entitled to the extent those items are assigned and, for
any proper purpose, to require reasonable information or account of transactions of the LLC and
to make reasonable inspection of the books and records of the LLC.586 Until the assignee
becomes a Member, the assignor continues to be a Member and to have the power to exercise
any rights or powers of a Member, except to the extent those rights or powers are assigned.587
An assignee of a membership interest may become a Member if and to the extent that the
Company Agreement so provides or all Members consent.588 Until an assignee is admitted as a
Member, the assignee does not have liability as a Member solely as a result of the assignment.589
The Company Agreement would typically contain restrictions on the assignment of
interests to facilitate compliance with applicable securities and tax laws. Membership interest
transfer restrictions contained in the Company Agreement are enforceable.590
O.
Dissolution
The LLC Act provides that an LLC is dissolved, and the TBOC requires than an LLC
commence winding up its affairs, upon the occurrence of any of the following events:
584
585
586
587
588
589
590
591
592
(1)
the expiration of the period (if any) fixed for its duration, which may be
perpetual;591
(2)
any event specified in the Articles or Company Agreement to cause dissolution,
or to require the winding up or termination, of the LLC;592
LLC ACT art. 4.05A; TBOC § 101.108.
Id.
LLC ACT art. 4.05A; TBOC § 101.109.
LLC ACT art. 4.05A; TBOC § 101.111.
LLC ACT art. 4.07A; TBOC §§ 101.109(b); 101.052. Under Tex. LLC Stats., an assignee who becomes a
Member (i) has (to the extent assigned) the rights and powers, and is subject to the restrictions of, a Member
under the Company Agreement and the Tex. LLC Stats., and (ii) becomes liable for the obligations of the
assignor to make contributions known to him at the time he becomes a member or as provided in the
Company Agreement, although the assignment does not release the assignor from his liabilities to the LLC.
LLC ACT art. 4.07B; TBOC §§ 101.110; 101.111(b).
LLC ACT art. 4.05C; TBOC § 101.109(c).
Tex. LLC Stats. provide that a membership interest is assignable unless otherwise provided by the Company
Agreement. LLC ACT art. 4.05A; TBOC § 101.108(a). There is no statutory requirement of “reasonableness”
with respect to LLC transfer restrictions as is found in TBCA section 2.22 and TBOC sections 21.211 and
21.213.
LLC ACT arts. 3.02A(2), 6.01A(1); TBOC § 11.051(1); see 1993 LLC Bill Analysis at 4.
LLC ACT art. 6.01A(2); TBOC § 11.051(3).
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(3)
the action of the Members to dissolve the LLC (in the absence of a specific
provision in the Articles or Company Agreement, the vote will be by a majority of
the Members);593
(4)
the occurrence of any event that terminates the continued membership of the last
remaining Member of the LLC, absent certain circumstances;594 or
(5)
entry of decree of judicial dissolution under the Tex. LLC Stats.595
However, an LLC may in many cases cancel the event that would otherwise require
dissolution or termination and carry on its business. The procedures for doing so differ both by
whether the LLC is governed by the TBOC or the LLC Act and by the type of event requiring
dissolution. Unless otherwise provided in its Company Agreement, the TBOC requires a
majority vote of all the LLC’s Members (or, if there are no Members, a majority vote of all its
Managers) to revoke a voluntary winding up, or a unanimous vote of all of its Members to
approve cancellation of an event that would otherwise require termination and winding up, other
than a judicial decree.596 Under the LLC Act and the TBOC, revocation of a voluntary
dissolution simply requires the written consent of all its members,597 while an election to
continue following the expiration of a fixed period of duration for the LLC or the occurrence of
events in the LLC’s governing documents requiring dissolution can only happen if there is at
least one remaining member and all members vote to continue (unless a lesser percentage is
specified in the Articles of Organization or Company Agreement).598
The time frames for permissible elections to continue in business also differ by governing
law and type of event of dissolution, and are all subject to restrictions in an LLC’s governing
documents. Where the event of dissolution is the termination of the LLC’s period of duration,
the TBOC allows three years for cancellation, whereas the LLC Act requires an election to
cancel within 90 days of the expiration, and subject to the amendment within three years of the
LLC’s formation document allowing for a longer duration.599 For voluntary dissolutions, the
LLC Act allows the LLC to cancel such dissolution within 120 days of the issuance of a
certificate of dissolution, whereas the TBOC mandates that such election be made before the
593
594
595
596
597
598
599
LLC ACT arts. 2.23D(2), 6.01A(3); TBOC §§ 11.051(2), 101.552. See 1993 LLC Bill Analysis at 5.
Additionally, the TBOC provides that if there are no members, dissolution may occur upon the majority vote
of the LLC’s managers. See TBOC § 101.552. This provision was intended to parallel the LLC Act provision
which provided for dissolution upon the act of a majority of the Managers or Members named in the Articles,
if no capital has been paid into the LLC and the LLC has not otherwise commenced business. LLC ACT art.
6.01A(4); see Revisor’s Note to TBOC § 101.552.
LLC ACT art. 6.01A(5), as amended by H.B. 1637 effective September 1, 2003; TBOC § 11.056. An LLC is
not dissolved upon the termination of membership of the last remaining Member if the legal representative
or successor of the last remaining Member agrees to continue the LLC and to become a Member as of the
date of the termination of the last remaining Member’s membership in the LLC or designates another
person who agrees to become a Member of the LLC as of the date of the termination. LLC ACT art. 6.01C
as amended by H.B. 1637 effective September 1, 2003; TBOC § 11.056.
LLC ACT art. 6.01A(6), 6.02A; TBOC § 11.051(5).
TBOC §§ 101.054, 101.552.
LLC ACT art. 6.06A; TBOC § 101.552.
LLC ACT art. 6.01B; TBOC § 101.552.
LLC ACT art. 6.01B; TBOC § 11.152(b).
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effective date of termination of the LLC’s existence.600 For the occurrence of an event
determined in the LLC’s governing documents to require automatic dissolution, the LLC Act
requires any cancellation election to be made within 90 days of the event, subject to amendment
of the LLC’s governing documents within three years to eliminate dissolution upon such event,
while the TBOC allows one year to revoke such dissolution.601 For other circumstances
requiring termination under the TBOC, LLCs are permitted one year to cancel the event of
termination.602
Since (i) under the Check-the-Box Regulations continuity of life is not an issue in
determining whether an LLC will be treated as a partnership for federal income tax purposes and
(ii) there is considerable flexibility under the Tex. LLC Stats. in defining the circumstances in
which an LLC is dissolved, the Certificate and Company Agreement should henceforth focus on
dissolution from a business rather than a tax standpoint. The result in many cases will be that the
LLC will not dissolve until the parties take affirmative action to cause dissolution.
Upon the dissolution of an LLC, its affairs must be wound up as soon as practicable by its
Managers, or Members or other persons as provided in its Certificate or Company Agreement or
by resolution of the Managers or Members.603 Before filing a certificate of termination with the
Secretary of State,604 the LLC shall (i) cease to carry on its business, except as may be necessary
for the winding up thereof, (ii) send written notice of its intention to dissolve to each of its
known creditors and claimants,605 and (iii) collect its assets, discharge its obligations or make
provisions thereof, and distribute the remaining assets to its Members.606 In the event a
dissolving LLC’s assets are not sufficient to discharge its obligations, the LLC is required to
apply the assets as far as they will go to the just and equitable payment of its obligations.607
Upon the filing of a certificate of termination with the Secretary of State, the existence of the
LLC terminates except for the purpose of suits and other proceedings by Members, Managers
and other LLC representatives.608
P.
600
601
602
603
604
605
606
607
608
Merger; Conversion
LLC ACT art. 6.06A; TBOC § 11.151.
LLC ACT art. 6.01B; TBOC § 11.152(a).
TBOC § 11.152(a).
LLC ACT art. 6.03A; TBOC § 101.551.
For entities still governed by the LLC Act, the proper filing document is articles of dissolution. See LLC
Act § 6.07. For the required elements that must appear in a certificate of termination under the TBOC, see
TBOC § 11.101.
Under Article 6.05 of the LLC Act, notice must be sent by registered or certified mail. Under the new
TBOC, notice must still be written, but can alternately be sent through a variety of technological means.
See Revisor’s Note to TBOC § 11.052.
LLC ACT art. 6.05; TBOC § 11.052.
LLC ACT art. 6.05(A)(3); TBOC § 11.053(b). The TBOC provides that such distribution may be delayed if
continuing the business for a limited period will prevent unreasonable loss of the LLC property. See TBOC §
11.053(d).
LLC ACT art. 6.08(B); TBOC §§ 11.055, 11.102. Under the LLC Act, such existence terminates upon the
issuance of a certificate of dissolution by the Secretary of State. LLC ACT art. 6.08B.
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Part Ten of LLC Act and Chapter 10 of the TBOC contain merger provisions that allow
an LLC to merge with one or more LLCs or “other entities” (i.e. any corporation, limited
partnership, general partnership, joint venture, joint stock company, cooperative, association,
bank, insurance company or other legal entity) to the extent that the laws or constituent
documents of the other entity permit the merger.609 The merger must be pursuant to a written
plan of merger containing certain provisions,610 and the entities involved must approve the
merger by the vote required by their respective governing laws and organizational documents.
Under Tex. LLC Stats., a merger is effective when the entities file an appropriate certificate of
merger with the Secretary of State, unless the plan of merger provides for delayed
effectiveness.611
An LLC’s merger with another entity must be approved by a majority of the LLC’s
members, unless its certificate of formation or Company Agreement specifies otherwise.612 The
Tex. LLC Stats. grant broad authority for who can execute merger documents on a company’s
behalf.613 Their provisions on short form mergers are broadly drafted to allow their application
to all types of entities that own, are owned by, or are under common ownership with a domestic
limited liability company in the required percentage.614
The Tex. LLC Stats. also authorize an LLC to convert into another form of entity, or
convert from another form of entity into an LLC, without going through a merger or transfer of
assets, and has provisions relating to the mechanics of the adoption of a plan of conversion,
owner approval, filings with the Secretary of State, and the protection of creditors.615
The Texas LLC Stats. allow the Company Agreement to provide whether, or to what
extent, Member approval of sales of all or substantially all of the LLC’s assets is required.616 In
the absence of a Company Agreement provision, the default under the TBOC is to require
Member approval for the sale of all or substantially all of the assets of an LLC.617
Q.
609
610
611
612
613
614
615
616
617
TLLCA Relationship to TBCA and TMCLA
However, the TBOC does impose restrictions on mergers involving nonprofit corporations. See TBOC §
10.010.
The LLC Act’s requirements appear in its Article 10.02. The TBOC’s requirements are in its Sections
10.002 and 10.003.
LLC ACT arts. 9.03, 10.03; TBOC § 10.007 and Revisor’s Note thereto.
LLC ACT art. 10.01A; TBOC §§ 10.001, 101.356, 101.052.
LLC ACT art. 10.03A; TBOC §§ 10.001(b), 10.151(b).
See LLC ACT art. 10.05; TBOC § 10.006.
LLC ACT arts. 10.08–.09; TBOC §§ 10.101–.105. Note, the TBOC permits LLCs still governed by the
LLC Act to convert into another entity form to be governed by the TBOC. TBOC § 10.102.
See supra notes 193–94 and accompanying text regarding the requirements of TBCA arts. 5.09–.10 and the
parallel TBOC provisions.
TBOC § 1.002(32) defines “fundamental business transaction” to include a “sale of all or substantially all of
the entity’s assets” and TBOC § 101.356 requires a member vote to approve any fundamental business
transaction, although TBOC § 101.052 would allow the parties to include in the Company Agreement
provisions that trump this TBOC requirement.
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While LLCs governed by the TBOC need only look to the TBOC to ascertain applicable
law, those LLCs still governed by the LLC Act are subject not only to that Act but also other preTBOC business entity statutes incorporated by reference thereto. The 1991 LLC Act section
8.12 provided that, to the extent that the LLC Act contains no provision with respect to one of
the matters provided for in the TBCA and the TMCLA, such acts (as amended from time to time)
will supplement the LLC Act to the extent not inconsistent with the LLC Act.618 In particular,
TBCA article 2.02-1 and Part 5 with respect to indemnification and mergers, respectively, and
TMCLA article 7.06 with respect to the limitation of director liability (made applicable to
Managers) were incorporated.619
The 1991 LLC Act was left relatively short to provide maximum flexibility to parties to
tailor their organizational structures to transactional needs. The references to the TBCA and
TMCLA were inserted to allow established bodies of law under those statutes to serve as gap
fillers in areas where the LLC Act, the Articles and the Company Agreement are silent. The
concept of “piercing the corporate veil,” which developed under the TBCA, is inconsistent with
the concept of limited liability for Members in the LLC Act and was not intended to be carried
over.620 The concepts of cumulative voting and preemptive rights, from TBCA articles 2.29D
and 2.22-1 respectively, may have been incorporated into the 1991 LLC Act by LLC Act section
8.12, although this conclusion is not free from doubt.
The Bar Committee preparing the 1993 amendments to the LLC Act concluded that the
1991 LLC Act section 8.12 was overbroad and presented interpretive difficulties and revised
LLC Act section 8.12 to designate the sections of the TBCA and the TMCLA incorporated by
reference. As amended in 1993, 1997 and 2003, LLC Act section 8.12A provides that only the
following TBCA articles apply to an LLC and its Members, Managers and officers:
2.07
2.08
4.14
5.14
Part Seven
(registered name)
(renewal of registered name)
(amendments of Articles, merger and dissolution pursuant to Federal
bankruptcy laws)
(derivative suits)
(involuntary dissolution and receivership)
LLC Act section 8.12B provides that the following TMCLA articles apply to an LLC, its
Members, Managers and officers:
2.03
2.04
2.05
2.06
2.09
2.09A
3.01
618
619
620
(obligations to ostensible LLC)
(exclusive right of trustee to sue under indentures and security documents)
(facsimile signatures on debt instruments)
(consideration for indebtedness and guarantees)
(interest rate on borrowings)
(alternative interest rate on borrowings)
(veteran entities)
1991 LLC ACT art. 8.12.
Id.
See LLC Act § 4.03; see also supra notes 563–567 and accompanying text.
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7.01–.05
(correction of defective filings with Secretary of State)
TMCLA articles 2.03, 2.04, 2.09 and 2.09A were repealed by H.B. 1165 effective
September 1, 2003, but LLC Act section 8.12B was not correspondingly amended.
TBCA concepts of cumulative voting and preemptive rights are not incorporated by
reference into the LLC Act. Organizers desiring to provide those rights must expressly provide
them in the Articles or Company Agreement, although an express denial thereof in the Articles
or Company Agreement still seems useful so that all parties will be aware of the result.
R.
Foreign LLCs
The Tex. LLC Stats. provide a mechanism by which a limited liability company formed
under the laws of another jurisdiction can qualify to do business in Texas as a foreign limited
liability company (a “Foreign LLC”) and thereby achieve in Texas the limited liability afforded
by the Tex. LLC Stats. to a domestic LLC.621 The LLC Act defines Foreign LLC broadly so that
business trusts and other entities afforded limited liability under the laws under which they were
organized, but which would not qualify for LLC status if formed in Texas, can still qualify to do
business and achieve limited liability in Texas.622 However, under the TBOC, such specific
provision was unnecessary, as such entities may register directly to transact business in Texas
under TBOC Chapter 9 and be afforded the limited liability shield.623 A foreign entity
comparable to a Texas LLC and doing business in Texas registers and thereby qualifies to do
business in Texas by filing an application to do so with the Secretary of State.624 The analysis of
whether a Foreign LLC is doing business in Texas so as to require qualification is the same as for
a foreign corporation.625
The internal affairs of a Foreign LLC, including the personal liability of its Members for
its obligations, are governed by the laws of its jurisdiction of organization.626 However, for
621
622
623
624
625
626
LLC Act Part Seven; TBOC chapter 101.
“Foreign limited liability company” is broadly defined in LLC ACT art. 1.02(9) as follows:
(9) “Foreign Limited Liability Company” means an entity formed under the laws of a
jurisdiction other than this state (a) that is characterized as a limited liability company by
such laws or (b) although not so characterized by such laws, that elects to procure a
certificate of authority pursuant to Article 7.01 of this act, that is formed under laws which
provide that some or all of the persons entitled to receive a distribution of the assets thereof
upon the entity’s dissolution or otherwise or to exercise voting rights with respect to an
interest in the entity shall not be liable for the debts, obligations or liabilities of the entity
and which is not eligible to become authorized to do business in this state under any other
statute.
See TBOC §§ 9.001, 101.001 and the Revisor’s Notes thereto.
LLC Act arts. 7.01A, 7.05; TBOC §§ 9.001, 9.004.
LLC Act art. 7.01B; TBCA § 8.01B; TBOC § 9.251.
LLC Act article 7.02 provides in relevant part as follows with respect to a Foreign LLC that has procured a
certificate of authority from the Secretary of State to transact business in Texas pursuant to LLC Act Part
Seven:
. . . only the laws of the jurisdiction of organization of a foreign limited liability company
shall govern (1) the internal affairs of the foreign limited liability company, including but
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matters affecting intrastate business in Texas, a Foreign LLC is subject to the same duties,
restrictions, and liabilities as a domestic LLC.627 The failure of a Foreign LLC to qualify to do
business in Texas will not impair the limitation on liability of its Members or Managers, which
gives specific effect to the applicability of the internal affairs doctrine relating to foreign entities
in the case of a non-qualified Foreign LLC.628
S.
Professional LLCs
Tex. LLC Stats. expressly provide for the formation of professional LLCs and specify the
statutory requirements for such entities.629 The pertinent provisions of the LLC Act (a
predecessor to the TBOC), including the definition of “professional service,” were based upon
the Texas Professional Corporation Act (“TPCA”).630 Physicians, surgeons and other doctors of
medicine are excluded from forming professional LLCs.631
A professional limited liability company (a “PLLC”) is required to contain in its name the
words ‘Professional Limited Liability Company’ or an abbreviation thereof.632 Only a
“professional individual”633 or a “professional organization”634 may be a governing person635 of a
not limited to the rights, powers, and duties of its manager and members and matters
relating to its ownership, and (2) the liability, if any, of members of the foreign limited
liability company for the debts, liabilities and obligations of the foreign limited liability
company for which they are not otherwise liable by statute or agreement.
The TBOC also provides for governance of a Foreign LLC’s internal affairs by the laws of its
jurisdiction of organization. In fact, such governance is in the TBOC’s very definition of “foreign
entity,” which states that the term “means an organization formed under, and the internal affairs of
which are governed by, the laws of a jurisdiction other than this state.” TBOC § 1.002(28).
627
628
629
630
631
632
633
634
635
LLC Act art. 7.02A; TBOC § 9.203.
LLC Act art. 7.13B; TBOC § 9.051(c).
See Part Eleven of the LLC ACT; see also TBOC chapters 301 and 304. The Texas Disciplinary Rules of
Professional Conduct permit Texas lawyers to form a Texas LLC for the practice of law. Op. Tex. Ethics
Comm’n No. 486 (1994). Most (but not all) states will also allow attorneys to practice in an LLC, at least so
long as the client is on notice of dealing with a limited liability entity and each lawyer rendering services to a
client remains fully accountable to the client. Lance Rogers, Questions of Law and Ethics Face Firms
Becoming LLPs, LLCs, in 12 ABA/BNA LAW. MANUAL ON PROF. CONDUCT 411 (No. 23, Dec. 11, 1996); see
ABA Comm. on Ethics and Prof’l Responsibility, Formal Op. 96-401 (1996).
TEX. REV. CIV. STAT. ANN. art. 1528e, §3(a) (Vernon 2002).
1993 LLC Bill Analysis at 6; LLC ACT art. 11.01; TBOC §§ 301.003, 301.012.
LLC Act art. 11.02; TBOC § 5.059.
The LLC Act defines “professional individual” to mean an individual who is licensed or otherwise
authorized to render the same professional service as the PLLC, either within Texas or in any other
jurisdiction. LLC ACT art. 11.01B(3); TBOC § 301.003(5).
TBOC § 301.003(7). The LLC Act uses the alternate term “professional entity,” LLC ACT art. 11.01B(4),
but either term indicates a person other than an individual that renders the same professional service as the
PLLC, only through owners, members, employees, agents, and the like, each of whom is either a
professional individual or professional organization or entity.
“Governing person” is a new term of art in the TBOC, and refers to a person entitled to manage and direct
an entity’s affairs under the TBOC and the entity’s governing documents. TBOC §§ 1.001(37), (35). In
terms of the LLC Act, the governing person would be the same as the members, if member-managed, and
the managers if manager-managed.
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PLLC.636 The PLLC, but not the other individual Members, Managers or officers, is jointly and
severally liable with a Member, Manager, officer, employee or agent rendering professional
service for an error, omission, negligence, incompetence, or malfeasance on the part of the
Member, Manager, officer, employee or agent when the Member, Manager, officer, employee or
agent is rendering professional service in the course of employment for the PLLC.637
T.
Diversity Jurisdiction
The cases are divided as to whether the citizenship of an LLC for federal diversity
jurisdiction purposes should be determined by analogy to a partnership or a corporation. Where
citizenship is determined in accordance with partnership precedent, an LLC is deemed a citizen
of each state in which it has a Member.638 Where corporate precedent is applied, an LLC is a
citizen of its state of incorporation and the state where its principal place of business is
located.639
VI.
LIMITED LIABILITY PARTNERSHIP640
A.
General
An LLP is a general partnership in which the individual liability of partners for
partnership obligations is substantially limited. This species of general partnership represents a
dramatic innovation and was first authorized in 1991 by provisions the LLP Provisions added to
the TUPA by Sections 83–85 of House Bill 278.641 The LLP Provisions were refined and carried
forward as section 3.08 of the TRPA642 passed in 1993, and then were substantially expanded by
S.B. 555 effective September 1, 1997.643
636
637
638
639
640
641
642
643
LLC Act art. 11.03A; TBOC §§ 301.007(a), 301.004(2).
LLC Act art. 11.05; TBOC § 301.010.
Int’l Flavors & Textures, LLC v. Gardner, 966 F.Supp. 552 (W.D. Mich. 1997).
SMS Fin. II, LLC v. Stewart, 1996 WL 722080 (N.D. Tex. 1996); Carlos v. Adamany, 1996 WL 210019
(N.D. Ill. 1996).
The discussion of LLPs herein, insofar as it relates to LLP’s under H.B. 278, is drawn in part from R. Dennis
Anderson, Alan R. Bromberg, Byron F. Egan, Campbell A. Griffin, Larry L. Schoenbrun and Charles
Szalkowski, Registered Limited Liability Partnerships, 55 TEX. B. J. 728 (July 1992).
Tex. H.B. 278, 72d Leg., R.S. (1991).
TRPA §1.01 et seq. (Vernon Supp. 2008).
Tex. S.B. 555, 75th Leg., R.S. (1997). Under TRPA section 11.03(b), TRPA section 3.08 governs all LLPs
between January 1, 1994 and December 31, 2005 (regardless of when formed). Its coverage continues until
December 31, 2009 for those LLPs formed prior to January 1, 2006 but not opting into the TBOC. However,
an LLP formed before January 1, 1994 and governed by the TRPA is subject to TUPA for the purposes of
determining liability for acts occurring prior to January 1, 1994. The TRPA phase-in provisions relating to
LLPs deal only with the LLP Provisions in TRPA section 3.08. The other aspects of a partnership entity
which is an LLP are governed by the remaining provisions of TRPA which have a different statutory phase-in.
TRPA section 11.03 provides that, except for section 3.08, TRPA applies on and after January 1, 1994 to (i)
new partnerships formed on and after that date and (ii) existing partnerships which elect to be governed by
TRPA; and all partnerships will be governed by TRPA after January 1, 1999 (though again, subject to the
phase in of the TBOC).
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The LLP provisions appearing in the new TBOC644 took effect on January 1, 2006 and
govern all LLPs formed on or after that date.645 The source LLP Provisions will govern LLPs
formed before that date which do not voluntarily opt in to TBOC governance until their
registrations expire, unless they are revoked or withdrawn prior to expiration.646 Registration
renewal, however, will be governed by the TBOC.647 The LLP Provisions or TBOC LLP
provisions, as each may be applicable to a particular LLP, will be hereinafter collectively
referred to as “Tex. LLP Stats.,” with differences between the two noted as appropriate.
B.
Background
The LLP Provisions of TUPA originated in a separate bill, Senate Bill 302 (“S.B. 302”)
(by Sen. John Montford). That bill was conceived as an alternate means for allowing
professionals the limitation of liability already available to them under the Texas Professional
Corporation Act.648 Although that statute allows professionals to limit their liability, the federal
income tax consequences of joining and separating from professional corporations often made
this avenue unavailable as a practical matter. The solution embodied in S.B. 302 was to amend
TUPA to allow professionals to achieve through a new kind of partnership the same liability
limitation already available in corporate form.649 Thus, the proposed amendments to TUPA that
were contained in S.B. 302 applied only to certain kinds of professional partners: physicians,
surgeons, other doctors of medicine, architects, attorneys at law, certified public accountants,
dentists, public accountants and veterinarians. S.B. 302 passed the Senate but encountered
criticism in hearings before the House Business and Commerce Committee on grounds, among
others, that the Bill was discriminatory against non-professional partnerships, that the Bill did
not tell persons dealing with a partnership whether the partnership had the liability shield, and
that the Bill did not require any substitute source of recovery for a person injured by partnership
misconduct.650 These criticisms led to the enlargement of the LLP Provisions to be applicable to
all partnerships, and to the addition of the requirements of LLP registration, use of LLP status
words or initials in the partnership name and maintenance by LLP’s of liability insurance. In this
form, the LLP Provisions were added to H.B. 278 in the Senate, and the House concurred in H.B.
278 as so amended. With the adoption of TRPA in House Bill 273 (“H.B. 273”), the LLP
Provisions of TUPA were refined and carried over into TRPA.
The LLP Provisions originated as part of a liability limiting trend that has included (i) the
LLC Act, (ii) amendments to the Texas Professional Corporation Act in 1989 and in H.B. 278,
(iii) the passage of TRPA in H.B. 273, maintaining the LLP entity created by H.B. 278, (iv) the
1989 and 1993 amendments to TBCA art. 2.21 to clarify non-liability of shareholders for
corporate contractual obligations, (v) the passage of TRLPA in 1987, which allowed limited
partners to engage in widely expanded activities without sacrificing their limited liability, and
644
645
646
647
648
649
650
See TBOC tit. 1, §§ 152.801–.805.
TBOC §§ 401.001, 402.003, 402.005.
TBOC § 402.001(b).
TBOC § 402.001(c).
TEX. REV. CIV. STAT. ANN. art. 1528e (Vernon Supp. 2006).
See Hamilton, Registered Limited Liability Partnerships: Present at the Birth (Nearly), 66 U. COLO. L. REV.
1065 (1995).
See TEX. LAW. 7 (May 13,1991); TEX. LAW. 1 (Oct. 2, 1991).
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(vi) the 1987 enactment and subsequent amendment of TMCLA art. 1302-7.06 authorizing the
limitation of liability of directors. These legislative changes were made during a period of
increasing litigation against individuals for actions that they allegedly took, or failed to take,
while serving as directors, officers or partners of a firm that failed or provided services to a firm
that failed. This litigation often involved amounts that dwarfed the net worth of the individuals
involved.
The LLP has spread beyond its Texas roots and now every state has adopted an LLP
statute. As the adoption of LLP statutes became more widespread, the LLP statutes of an
increasing number of states protected partners from liabilities arising other than from the
negligence, malpractice, wrongful acts or misconduct of other partners and employees.651 The
“full shield” LLP statutes of a number of states (including Colorado, Georgia, Idaho, Indiana,
Maryland, Minnesota, and New York) insulate a partner from personal liability for any debts,
obligations or liabilities of, or chargeable to, the partnership, if such liability would exist solely
by reason of their being partners, rendering professional services, or participating in the conduct
of the business of the LLP, but do not protect a partner from liability arising from the partner’s
own negligence, wrongful acts or misconduct, or from that of any person acting under his direct
supervision and control.652
Although Texas was the first jurisdiction in the nation to permit the creation of limited
liability partnerships, TRPA lagged behind other jurisdictions in providing partners of limited
liability partnerships with protection from liabilities of the partnership. To address this
deficiency, S.B. 555 amended TRPA section 3.08 to bring the Texas statute more in line with the
laws of other jurisdictions relating to limited liability partnerships, in particular the liability of
partners of a limited liability partnership for contractual obligations. TRPA section 3.08(a), as
amended, provides that, except for liability for errors, omissions, negligence, incompetence or
malfeasance committed by, or attributed to, a partner in a registered limited liability partnership,
a partner will not be individually liable, directly or indirectly, by contribution, indemnity or
otherwise, for the debts and obligations of the partnership incurred while the partnership is a
registered limited liability partnership.653 The new TBOC affords LLP partners the same
protection.654 This provision, however, does not apply to the liability of a partnership to pay its
debts and obligations out of partnership property, the liability of a partner, if any, imposed by
law or contract independently of the partner’s status as a partner, or the manner in which service
of citation or other civil process may be served in an action against the partnership.
A new subsection (5) was added to TRPA section 3.08(a)655 to provide that in the case of
a registered limited liability partnership, the limitations of liability provided in subsection (a) will
prevail over other parts of TRPA regarding the liability of partners, their chargeability for the
debts and obligations of the partnership and their obligations regarding contributions and
indemnity.
651
652
653
654
655
See, e.g., N.Y. Partnership Law § 26(b) (McKinney 1988 & Supp.); Hamilton, supra note 649, at 1097.
N.Y. Partnership Law § 26(c), (d) (McKinney 1988 & Supp.).
TRPA § 3.08
TBOC § 152.801.
The TBOC’s parallel provision is in § 152.801(f).
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The amendment to TRPA section 3.08 relating to limitation of liability of partners of a
limited liability partnership does not impair the obligations under a contract existing before the
effective date of S.B. 555.656 Thus, the partners of an LLP which was subject to a long-term
lease entered into prior to September 1, 1997 remain personally liable for those lease obligations
notwithstanding the amendment of TRPA section 3.08, although they would be shielded against
contractual obligations created thereafter. Similarly, for organizations subject to the TBOC, the
TBOC’s provisions govern contracts the LLP enters on and after the first date the TBOC applies
to the LLP, but prior law governs any contracts entered into under such old law.657
TRPA section 8.06 was amended by S.B. 555 to clarify that the obligations of a partner to
make contributions to a partnership for the partner’s negative balance in the partner’s capital
account and to satisfy obligations are subject to the limitations contained in TRPA section 3.07
and 3.08 relating to LLPs and the liability of incoming partners. TBOC section 152.707 provides
substantially the same.
C.
Liability Shielded
Partners in a general partnership that is not an LLP are individually liable, jointly and
severally, for all partnership obligations, including partnership liabilities arising from the
misconduct of other partners, although under Texas law a creditor generally must first seek to
satisfy the obligations out of partnership property.658 Although an LLP is a general partnership,
the general partnership joint and several liability scheme is dramatically altered by the Tex. LLP
Stats. when LLP status is attained.
1.
LLP Shield
The essence of the Tex. LLP Stats. shield is to relieve a partner from individual liability
for partnership obligations, except to the extent that they are attributable to the fault of the
partner. The shield is set forth in TBOC section 152.801 as follows:
Sec. 152.801. Liability of Partner.
(a) Except as provided by Subsection (b), a partner in a limited liability
partnership is not personally liable, directly or indirectly, by contribution,
indemnity, or otherwise, for a debt or obligation of the partnership incurred while
the partnership is a limited liability partnership.
(b) A partner in a limited liability partnership is not personally liable for a
debt or obligation of the partnership arising from an error, omission, negligence,
incompetence, or malfeasance committed by another partner or representative of
656
S.B. 555 section 125(d) provides as follows:
(d) The change to Article 3.08, Texas Revised Partnership Act (Article
6132b-3.08, Vernon’s Texas Civil Statutes), made by this Act shall not impair the
obligations of a contract existing before the effective date of this Act.
657
658
TBOC § 402.006.
TRPA § 3.05(a), (d)–(e); TBOC § 152.306(b). See BROMBERG & RIBSTEIN, supra note 303, § 1.01 and ch. 5
for a general discussion of the liabilities of general partners.
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the partnership while the partnership is a limited liability partnership and in the
course of the partnership business unless the first partner:
(1) was supervising or directing the other partner or representative when
the error, omission, negligence, incompetence, or malfeasance was
committed by the other partner or representative;
(2) was directly involved in the specific activity in which the error,
omission, negligence, incompetence, or malfeasance was committed
by the other partner or representative; or
(3) had notice or knowledge of the error, omission, negligence,
incompetence, or malfeasance by the other partner or representative
at the time of the occurrence and then failed to take reasonable action
to prevent or cure the error, omission, negligence, incompetence, or
malfeasance.
(c)
Sections 2.101(1), 152.305, and 152.306 do not limit the effect of
Subsection (a) in a limited liability partnership.
(d) In this section, "representative" includes an agent, servant, or employee
of a limited liability partnership.
(e) Subsections (a) and (b) do not affect:
(1) the liability of a partnership to pay its debts and obligations from
partnership property;
(2) the liability of a partner, if any, imposed by law or contract
independently of the partner’s status as a partner; or
(3) the manner in which service of citation or other civil process may be
served in an action against a partnership.
(f) This section controls over the other parts of this chapter and the other
partnership provisions regarding the liability of partners of a limited liability
partnership, the chargeability of the partners for the debts and obligations of the
partnership, and the obligations of the partners regarding contributions and
indemnity.
These provisions are substantially the same as those found in TRPA section 3.08(a).
2.
Limits to LLP Shield
The Tex. LLP Stats. expressly do not relieve a partner for any liability imposed by law or
contract independently of his status as a partner, including torts committed by him while acting
on behalf of the partnership.659 In addition, there are three situations in which the statutes do not
shield a partner from liability for a partnership obligation arising from the specified misconduct
of a copartner or representative of the partnership:
(1)
659
660
The miscreant copartner or representative is working under the
supervision or direction of the partner.660
TRPA § 3.08(a)(3)(B); TBOC § 152.801(e).
TRPA § 3.08(a)(2); TBOC § 152.801(b)(1).
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(2)
The partner is directly involved in the specific activity in which the
copartner or representative commits the misconduct.661
(3)
The partner has “notice” or “knowledge” of the misconduct at the time of
occurrence and fails to take reasonable steps to prevent the misconduct.662
All three situations involve fact questions as well as legal interpretations of the statutory
language.
In situation (1), the supervision should be direct, or the direction should be specific, for
the exception to apply. The language in situation (1) was not intended to deny the liability shield
to someone (such as a managing or senior partner) who exercises indirect supervision over all
partnership activity or over a particular segment of the partnership’s business or who generally
directs other partners by establishing policies and procedures or by assigning responsibilities.
In situation (2), the direct involvement should relate to the particular aspect of the
endeavor in which the misconduct occurred. The language in situation (2) was not intended to
deny the liability shield to someone who was directly involved in one facet of a multifaceted
matter (e.g., one involving several different areas of expertise) but did not participate in that facet
of the matter that gave rise to the liability.
Neither exception (1) nor (2) should denude someone who had direct supervisory
responsibility for, and therefore was directly involved in, a particular project but was not directly
supervising the person who engaged in misconduct or directly involved in the aspect of the
project in which the misconduct occurred.663 For example, an environmental lawyer who
negligently rendered legal advice with respect to the environmental law aspects of a real property
acquisition would not ordinarily be viewed as “working under the supervision or direction” of a
real estate lawyer having overall responsibility for the acquisition. This means that exception (1)
would not be applicable. Further, the real estate lawyer would not ordinarily be viewed as
“involved in the specific activity” in which the misconduct occurred (i.e., advising with respect
to environmental law), which means that exception (2) would not apply.
3.
Burden of Proof
The liability shield of the Tex. LLP Stats. is an affirmative defense, with the burden of
proof on the partner claiming its benefit to show that the partnership is an LLP (i.e. that it
661
662
663
TRPA § 3.08(a)(2)(A); TBOC § 152.801(b)(2).
TRPA § 3.08(a)(2)(B); TBOC § 152.801(b)(3). Tex. LLP Stats. provide that a person has “notice” of a fact if
such person (i) has actual knowledge of such fact, (ii) has received a communication of the fact, or (iii)
reasonably should have concluded, from all facts known to such person at the time in question, that the fact
exists. A person is treated as having received a communication of a fact if the fact is communicated to the
person, the person’s place of business, or another place held out by the person as the place for receipt of
communications. TRPA § 1.02; TBOC § 151.003.
But see Fortney, Am I My Partner’s Keeper? Peer Review in Law Firms, 66 U. COL. L. REV. 329, 331–32
(1995) (notes that in six “actions brought in connection with failed savings and loan associations, the
government has alleged that each law firm partner is personally liable for failing to monitor the conduct of
other firm partners. In making such allegations the government has asserted that the failure to monitor claims
are distinct from the vicarious liability claims,” for which the LLP shield was designed).
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complied at the relevant time(s) with the registration, name and insurance requirements). The
burden would then shift to the plaintiff to prove that one or more of the three exceptions apply to
remove the liability shield from particular partners.
4.
LLP Status Does Not Affect Liability of Partnership
LLP status does not relieve a partnership itself from liability for misconduct of its
partners or representatives or prevent its assets from being reached to satisfy partnership
obligations.664 A partnership may still be sued as an entity in its common name under Rule 28 of
the Texas Rules of Civil Procedure, with or without the partners.665 Citation or other process
against a partnership may still be served on a partner under Section 17.022 of the Texas Civil
Practice and Remedies Code, regardless of whether the partner is shielded from liability by the
partnership’s LLP status.666
5.
Shielded vs. Unshielded Obligations
The LLP shield only applies to the liability of partners for the covered partnership
obligations incurred while the partnership is an LLP.667 The partners remain jointly and
severally liable for all other partnership obligations. A partnership at any time may have both
shielded and unshielded obligations.
The Tex. LLP Stats. do not deal with the right of a partnership to pay unshielded
obligations before paying shielded obligations or whether partner contributions may be
earmarked to cover particular unshielded obligations. These matters are left to fiduciary
principles and laws pertaining to creditors rights.
6.
Contractual Obligations Incurred Prior to September 1, 1997
The amendment to TRPA section 3.08 making Texas a full shield state does not apply to
contractual obligations incurred prior to the September 1, 1997 effective date of S.B. 555 by
virtue of S.B. 555 section 125(d), which provides as follows:
“(d) The change to Article 3.08, Texas Revised Partnership Act (Article
6132b-3.08, Vernon’s Texas Civil Statutes), made by this Act shall not impair the
obligations of a contract existing before the effective date of this Act.”
Such obligations are similarly unshielded for partnerships governed by the TBOC.668 Thus, the
partners of an LLP which was subject to a long term lease entered into prior to September 1,
664
665
666
667
668
TRPA section 3.08(a)(3)(A) and TBOC section 152.801(e)(1) provide that the other Texas LLP provisions
“do not affect . . . the liability of a partnership to pay its debts and obligations [out of] partnership property.”
TEX. R. CIV. P. 28.
TRPA § 3.08(a)(3)(C) (Vernon Supp. 2008).
See Elmer v. Santa Fe Properties, Inc., 2006 WL 3612359 (Tex. App.—San Antonio 2006, no pet. h.)
(partner held liable for LLP lease obligations because it “was not a properly registered limited liability
partnership when it incurred its lease obligations” because it did not have the required insurance at that
time).
TBOC § 402.006.
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1997 remain personally liable for those lease obligations notwithstanding the amendment of
TRPA section 3.08, although the same obligation incurred thereafter would be shielded unless
the partners had agreed to be liable therefor.
7.
Other State LLP Statutes
In the other states that have LLP statutes, the scope of liability from which an innocent
partner in an LLP is protected varies from state to state. Some LLP statutes only protect partners
from vicarious liability for tort-type liabilities (“partial shield”), while others provide a “full
shield” of protection from both tort and contract liabilities of the partnership,669 perhaps in
recognition that some malpractice claims could be pled in contract as well as in tort.670 Under
most LLP statutes, including that of Delaware,671 a partner is liable not only for his own
negligence, malpractice, wrongful act or misconduct, but also for that of someone under his
direct supervision and control. The Maryland LLP statute preserves liability for a partner who is
negligent in appointing, supervising or cooperating with the partner, employee or agent who was
negligent or committed the wrongful act or omission.672 At least two states, Kentucky and Utah,
have adopted LLP statutes providing that a partner is personally liable only for his own
negligence, malpractice, wrongful acts and misconduct.673
D.
Requirements for LLP Status
Each of the three requirements described below must be satisfied in order for the LLP
shield to be in place in Texas. Creditors seeking to break the shield can be expected to require
proof of satisfaction of each of the conditions and to challenge any noncompliance.
1.
Name
The Tex. LLP Stats. require that an LLP must include in its name the words “limited
liability partnership” or an abbreviation thereof.674
669
670
671
672
673
674
See Bishop, The Limited Liability Partnership Amendments to the Uniform Partnership Act (1994), 53 BUS.
LAW. 101 (Nov. 1997), which contains a table of LLP Liability Shield Features (through October 31, 1997)
showing those LLP statutes which are full shield or partial shield).
Miller, Procedural and Conflict Laws Issues Arising In Connection With Multi-State Partnerships (ABA BUS.
L. SEC. 1996 Spring Meeting).
DEL. CODE ANN. tit. 6, § 1515 (1999 & Supp. 2005).
MD. CORP. & ASS’N. CODE ANN. § 9A-306(d)(1) (1999).
See KY. REV. STAT. ANN. § 362.220 (Michie 2002); UTAH CODE ANN. § 48-1-12(2) (2002).
TRPA § 3.08(c); TBOC § 5.063; TEX. ADMIN. CODE tit. 1, § 80.1(b) (2003). Under the TRPA, LLPs were
officially called registered limited liability partnerships. The TRPA also imposed additional restrictions
regarding an LLP’s name which have been omitted from the TBOC. See Revisor’s Notes to TBOC §§
1.002(48) and 5.063. A firm with a written partnership agreement should amend the agreement to include the
required words or letters as part of its name.
Compliance with the Texas name requirements by a law firm should not conflict with the misleading name
prohibition in Rule 7.01 of Texas Disciplinary Rules of Professional Conduct, which provides in relevant part
as follows:
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2.
Filing with the Secretary of State of Texas
LLPs are considered to be non-filing entities under the TBOC.675 Nonetheless, to achieve
domestic LLP status, a partnership must file with the Secretary of State of Texas676 an
application accompanied by a fee for each partner of $200.677 The application must (a) state the
name of the partnership, the address of its principal office, the number of partners and the
business in which the partnership engages, plus the federal tax identification number of the
partnership,678 and (b) be executed by a majority in interest679 of the partners or by one or more
partners authorized by a majority in interest of the partners. The Tex. LLP Stats. do not require
that an LLP filing with the Secretary of State have any express authorization in the partnership
agreement, but changing the name to include the required words or abbreviation required by Tex.
LLP Stats. would ordinarily require that the partnership agreement contemplate LLP status.680
If the required information is supplied in the application and the fee is paid, the LLP
registration becomes effective upon filing.681 There is no requirement for the Secretary of State
(a) A lawyer in private practice shall not practice under a trade name, a name that is
misleading as to the identity of the lawyer or lawyers practicing under such name, or a firm
name containing names other than those of one or more of the lawyers in the firm, except
that the names of a professional corporation or professional association may contain “P.C.”
or “P.A.” or similar symbols indicating the nature of the organization . . . [Emphasis added].
The underscored language was in Rule 7.04 before LLPs were authorized and was intended to clarify that it is
permissible to include in a firm name words, initials or symbols indicating the nature of the limited liability
form of organization. The references to “professional corporation,” “professional association,” “P.C.” and
“P.A.” are by way of example and not limitation, and they do not limit the use of the words or letters
“registered limited liability partnership” or “L.L.P.” in a firm name. The legislative history of the LLP
Provisions clearly shows that the legislature intended the LLP form of business organization to be available to
firms of lawyers and other professionals.
675
676
677
678
679
680
681
See TBOC §§ 1.002(57), (34).
The rules of the Secretary of State dealing with LLP filings may be found at TEX. ADMIN. CODE tit. 1,
§§ 80.1–.7 (2003) as well as TRPA § 3.08(b) and TBOC § 152.802.
The $200 per partner fee for LLPs organizing under Texas law is based on the total partners in the firm, and
not the number of partners in Texas, under TRPA section 3.08(b)(3) and TBOC section 4.158(1). For a
foreign LLP, the fee is $200 per partner in Texas, not to exceed $750, under TRPA section 10.02(c) and
TBOC section 4.158(1).
The Secretary of State’s form of application and the Tex. LLP Stats. require the tax identification number of
the partnership as part of the application to provide more positive identification than the partnership name,
which may change or may be similar to other names.
“Majority in interest” is defined in TRPA section 1.01(10), TRLPA section 1.02(7), and TBOC section
151.001(3) as more than 50% of the current interest in profits of the partnership. Although not required by the
Secretary of State’s form or the Tex. LLP Stats., it is prudent for an application to recite that it is signed by a
majority in interest of the partners or by one or more partners authorized by a majority in interest of the
partners.
In some states, electing LLP status requires unanimous partner approval or an amendment to the partnership
agreement in accordance with the applicable partnership agreement provisions. See Bishop, The Limited
Liability Partnership Amendments to the Uniform Partnership Act (1994), 53 BUS. LAW. 101, 114–15 (Nov.
1997).
TBOC § 4.051. The Secretary of State must register or renew as an LLP any partnership that submits a
completed application with the required fee. See Tex. Admin. Code tit. 1, § 80.3 (2008); TBOC § 4.002.
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to issue a certificate. As evidence of the filing, the Secretary of State will return a file-stamped
duplicate of the application. The Tex. LLP Stats. now permit electronic filings of LLP
documents as soon as the Secretary of State’s procedures will permit.682
Registration remains effective for a year,683 regardless of changes in the partnership,
unless the registration is earlier withdrawn or revoked or unless renewed.684 Because the
registration is a notice filing and no listing of partners is required in the application, partnership
changes due to withdrawals or to admissions of new partners do not require any refiling with the
Secretary of State until the next renewal filing.685 Caution suggests an amendment to the
application if the partnership changes its name. LLP’s should arrange their own reminders, since
the Secretary of State is not obliged to send renewal notices.
3.
Insurance or Financial Responsibility
The third requirement for LLP status under Tex. LLP Stats. is that the
partnership must:
“(1)
carry at least $100,000 of liability insurance of a kind that is
designed to cover the kind of error, omission, negligence, incompetence, or
malfeasance for which liability is limited by Section 152.801(b); or
(2)
provide $100,000 specifically designated and segregated for the
satisfaction of judgments against the partnership for the kind of error, omission,
negligence, incompetence, or malfeasance for which liability is limited by
Section 152.801(b) by:
(A) deposit of cash, bank certificates of deposit, or United States
Treasury obligations in trust or bank escrow;
(B) a bank letter of credit; or
(C) insurance company bond.”686
The requirement that the partnership “carry at least $100,000 of liability insurance of a kind that
is designed to cover the kind of error, omission, negligence, incompetence, or malfeasance for
which liability is limited by” the Tex. LLP Stats. (and the option to provide $100,000 of funds
instead) is intended to provide some source of recovery as a substitute for the assets of partners
who are shielded from liability by the Tex. LLP Stats. The $100,000 figure is arbitrary and may
or may not be greater than the partners’ individual assets otherwise available to partnership
creditors. Nevertheless, the maintenance by the LLP of the required $100,000 of insurance or
682
683
684
685
686
TRPA § 3.08(b)(16); TBOC § 4.001(a)(2).
TRPA § 3.08(b)(5); TBOC § 152.802(e).
TRPA §§ 3.08(b)(6)–(7); TBOC § 152.802(e).
See TRLPA § 3.08(b)(4); TEX. ADMIN. CODE tit. 1, §§ 80.1 and 80.4 (2008); see also TBOC § 152.802(d).
TBOC § 152.804(a). TRPA section 3.08(d)(1) provides substantially the same. The partnership should, of
course, be a named insured. While a policy naming only the partners may suffice, caution suggests not
relying on this approach.
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segregated funds at the time a liability is incurred is a requirement for the liability to be shielded,
and it is not sufficient that a partner individually maintains insurance in such amount.687
The $100,000 requirement refers to the liability limit of the insurance, above any
deductibles, retentions or similar arrangements; thus, deductibles, retentions and the like are
permitted so long as the coverage would allow aggregate proceeds of at least $100,000. The
statute is not explicit about the effect on one claim of exhaustion of the policy limits by a prior
claim. The intent is clear that exhaustion by one claim does not remove the liability shield for
the same claim. If an LLP had the requisite insurance in place at the time the error or omission
occurred, the insurance requirement should be satisfied even though subsequent events made the
coverage unavailable to the aggrieved party. For example, if there were a number of lawsuits
pending against an LLP at the time an error or omission occurred and judgments subsequently
entered depleted the insurance available for the aggrieved party, the subsequent events should
not retroactively deny the LLP shield to the partnership. Renewal or replacement of policies on
their periodic expirations is probably enough to satisfy the insurance requirement of TRPA
section 3.08(d) and TBOC section 152.804.
The insurance must be “designed to cover the kinds of” acts for which partner liability is
shielded by Tex. LLP Stats.688 The quoted phrase contains some flexibility; actual coverage of
the misconduct that occurs is not an absolute necessity. The partner claiming the shield from
liability, however, has the burden of proof that the insurance satisfied this statutory requirement.
Insurance coverage for particular conduct is not always available. TRPA section 3.08(d)
and TBOC section 152.804(a) allow an LLP the option of providing $100,000 in funds in lieu of
obtaining insurance, but require one or the other. Proof of compliance with the insurance or
financial responsibility requirements is on the partner claiming the liability shield of TBOC
section 152.801 or TRPA section 3.08(a).689
The Tex. LLP Stats. provide that the LLP insurance requirements “shall not be
admissible nor in any way made known to the jury in determining the issue(s) of liability for or
extent of the debt or obligation or damages in question.”690 These provisions are intended to
keep the existence of insurance from influencing a jury decision on liability or damages. Tex.
LLP Stats. specifically state that if compliance with their insurance or fund provisions is
687
688
689
690
In Elmer v. Santa Fe Props., Inc., 2006 WL 3612359 (Tex. App.—San Antonio 2006), a partner of an LLP
was held personally liable for the LLP’s obligations under a lease executed at a time when the LLP was not
in compliance with the requirement of the applicable LLP Stats. that an LLP maintain liability insurance of
at least $100,000 “of a kind that is designed to cover the kinds of errors, omissions, negligence,
incompetence, or malfeasance for which liability is limited by” the LLP Stats. It did not matter that (i) a
judgment was first obtained against the partnership on pleadings alleging that the partnership was an LLP,
(ii) the individual partner sued in the case had actually maintained errors and omissions coverage for
himself individually (the Tex. LLP Stats. require that the insurance cover the partnership and covering an
individual partner is not good enough—substantial compliance is not enough under the Tex. LLP Stats:
strict compliance is required), and (iii) the liability at issue was a contract obligation rather than the kind of
tort liability for which the statutorily required insurance would provide coverage.
TRPA § 3.08(d)(1)(A); TBOC § 152.804(a)(1).
See TRPA § 3.08(d)(3); TBOC § 152.804(c).
TRPA § 3.08(d)(2); see also TBOC § 152.804(b).
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disputed, “compliance must be determined separately from the trial or proceeding” to determine
liability or damages.691
E.
Taxation
1.
Federal Tax Classification
If a domestic LLP has two or more members, then it can be classified as a partnership for
federal income tax purposes under the Check-the-Box Regulations.
2.
Texas Entity Taxes
As a species of general partnership, an LLP was not subject to the Texas franchise tax.692
Effective for tax years beginning on or after January 1, 2007, the Margin Tax is imposed on
LLPs, although the LLP is a species of general partnership to which the Margin Tax is not
applicable.693
3.
Self-Employment Tax
Partners in an LLP generally will be subject to self-employment tax on their share of the
trade or business income of the LLP since an LLP is a species of general partnership and under
state law different from a limited partnership.694
F.
Other Issues
1.
Advertisement of LLP Status
Although not required by the Tex. LLP Stats., an LLP should include the LLP words or
initials wherever the partnership’s name is used, e.g., on directory listings, signs, letterheads,
business cards and other documents that typically contain the name of the partnership. Although
the LLP designation is part of the partnership’s name and should be used as such, it is common
and should be permissible for some partnership communications to be shorthanded and omit the
designation. A rule of reason should apply in deciding how far a partnership should go in using
the LLP designation. Thus, a partnership should, in answering the telephone, be able to use a
shortened version of its name that does not refer to its LLP status and, when an existing
partnership elects to become an LLP, it should have a reasonable period of time in which to
implement the use of the LLP status words or symbols in printed matter and should be able to
use up existing supplies of letterhead, etc.
There is no requirement, beyond the name change, that a partnership that becomes an
LLP notify its customers, clients or patients of the partnership’s new status. Further, there is no
691
692
693
694
TRPA § 3.08(d)(3); see also TBOC § 152.804(c).
TEX. TAX CODE ANN. § 171.001 (Vernon 2002 and Supp. 2004).
See discussions supra Part I. General—E. Texas Entity Taxation—3. Margin Tax and Part I. General—E.
Texas Entity Taxation—4. Constitutionality of Margin Tax.
Burgess J. W. Raby & William L. Raby, Partners, LLC Members, and SE Tax, 87 TAX NOTES 665, 668
(April 26, 2000).
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requirement that a partnership publish notice of its becoming an LLP comparable to the notice
required of certain incorporations in other states.695
2.
Assumed Name Certificate
Since an LLP is a species of general partnership, prior to House Bill (“H.B. 1239”) which
became effective September 1, 1993, an LLP was required to make filings under the Texas
Assumed Business or Professional Name Act (the “Assumed Name Statute”)696 like any other
general partnership. H.B. 1239 sections 1.29–.31 amended the Assumed Name Statute so that
LLPs, LLCs and limited partnerships are not deemed to be conducting business under an
“assumed name,” and do not have to make filings under the Assumed Name Statute if they
conduct business in the same name as shown in their documents on file in the office of the
Secretary of State. However, a general partnership which is not an LLP would have to file under
the Assumed Name Statute if it conducted business under a name that does not include the
surname or legal name of each general partner.697 If an LLP, LLC or limited partnership
regularly conducts business under any other name (an “assumed name”), it would be required to
file in the office of the county clerk of each county in which it maintains a business or
professional premises a certificate setting forth the assumed name of the firm and the name and
residence address of each general partner.698 Failure to comply with the filing requirements of
the Assumed Name Statute should not affect the partnership’s LLP status but would subject the
partnership to the penalties specified in the Assumed Name Statute.699 Although under the
Assumed Name Statute it would be possible for an LLP to adopt an assumed name that did not
include the LLP designation, failure to include the designation is inadvisable since it would
frustrate the LLP Act requirement that the designation be in the firm name.
3.
Time of Compliance
A partnership must be in compliance with the Tex. LLP Stats. requirements for an LLP at
the time of misconduct giving rise to an obligation in order to raise the liability shield. Texas
law explicitly states that the shielded partners are not liable for misconduct incurred while the
partnership is a limited liability partnership.700
The liabilities of a general partnership that incorporates or becomes a limited partnership
remain the individual liabilities of the former general partners notwithstanding the assumption of
those liabilities by the new entity.701 Likewise, dissolution of a corporation or limited
695
696
697
698
699
700
701
The New York LLP statute requires publication of a notice once per week for six weeks upon creation of an
LLP. N.Y. Partnership Law § 121-1500(a)(9) (McKinney Supp. 2004).
TEX. BUS. & COM. CODE § 36.01ff (Vernon 2002).
TEX. BUS. & COM. CODE § 36.02(7) as amended by H.B. 1239.
TEX. BUS. & COM. CODE § 36.10 as amended by H.B. 1239.
TEX. BUS. & COM. CODE §§ 36.25 and 36.26.
TBOC § 152.801(a); see also TRPA § 3.08(a)(1). This result is buttressed by the Bar Committee Bill
Analysis of H.B. 273 which at 14 states that TRPA section 3.08(a)(1) “clarifies that the partnership must be
a registered limited liability partnership at the time of the errors and omissions for which partner liability is
limited.”
Id.; see also Baca v. Weldon, 230 S.W.2d 552 (Tex. Civ. App.—San Antonio, 1950, writ ref’d n.r.e.).
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partnership does not result in the liability of its shareholders or limited partners for the entity’s
obligations.702 Thus, for example, if an LLP were to dissolve, its partners should not lose the
liability shield in an action brought during winding up for misconduct that occurred before
dissolution.
4.
Effect on Pre-LLP Liabilities
An LLP is the same partnership that existed before it became an LLP.703 Since the Tex.
LLP Stats. shield protects partners only against liabilities incurred while the partnership is an
LLP, attainment of LLP status has no effect on pre-existing partnership liabilities. In Medical
Designs, Inc. v. Shannon, Gracey, Ratliff & Miller, L.L.P.,704 a law firm was sued for malpractice
and obtained a summary judgment that was upheld on appeal on the basis that a “successor
partnership” is not liable for the torts of a predecessor partnership, although the liabilities of the
prior partners would remain their liabilities. The law firm defendant had, subsequent to the time
the alleged malpractice occurred, merged and unmerged with another law firm, and the miscreant
partner of the prior partnership was not associated with the defendant law firm. Under these
facts the court of appeals wrote, “Texas does not recognize that successor partnerships are liable
for the tortious conduct of predecessor partnerships.”705 However, there is nothing in the court’s
opinion suggesting that registration as an LLP is enough to make the partnership a different
partnership.706
5.
Limited Partnership as LLP
A limited partnership can become an LLP simply by complying with the applicable LLP
provisions, in which case it would be a “LLLP.”707 In addition, Tex. LLP Stats. provide that a
limited partnership is an LLP as well as a limited partnership if it (i) registers as an LLP under
the proper provisions,708 as permitted by its partnership agreement or with the consent of partners
required to amend its partnership agreement to so permit, (ii) complies with the insurance or
financial responsibility provisions of Tex. LLP Stats.,709 and (iii) contains in its name “limited
liability partnership” or an abbreviation thereof.710711
702
703
704
705
706
707
708
709
710
See Hunter v. Fort Worth Capital Corp., 620 S.W.2d 547 (Tex. 1981); Anderson v. Hodge Boats & Motors,
Inc., 814 S.W.2d 894 (Tex. App.—Beaumont 1991).
See Middlemist v. BDO Seidman, LLP, 958 P.2d 486, (Colo. Ct. App. 1997); Sasaki v. McKinnon, 707 N.E.
2d 9, (Ohio Ct. App. 1997); and Howard v. Klynveld Peat Marwick Goerdeler, 977 F. Supp. 654 (S.D. N.Y.
1997).
922 S.W.2d 626 (Tex. App.—Fort Worth 1996, writ denied).
Id. at 629.
For an analysis of the Shannon, Gracey case, see Elizabeth S. Miller, The Advent of LLCs and LLPs in the
Case Law: A Survey of Cases Dealing With Registered Limited Liability Partnerships and Limited Liability
Companies presented at symposium on Partnerships and LLCs—Important Case Law Developments 1998 at
ABA Annual Meeting in Toronto, Ontario, Canada on August 4, 1998.
See TRPA § 3.08(e); TBOC §§ 152.805, 1.002(47).
TRPA § 3.08(b); TBOC § 152.802.
TRPA § 3.08(d); TBOC § 152.804.
TBOC § 5.055(b). The name requirements differ slightly for entities still governed by the TRLPA. See
TRLPA § 2.14(a)(3).
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In an LLLP the general partners should have the same liability shield as partners in any
other LLP. In a limited partnership, a limited partner is not liable to creditors unless (i) the
limited partner participates in the control of the business and (ii) the creditor reasonably believed
that the limited partner was a general partner.712 Under Tex. LLP Stats., a limited partner in an
LLLP whose conduct would otherwise render it liable as a general partner has the benefit of the
LLP shield.713
6.
Indemnification and Contribution
The Tex. LLP Stats. eliminate the usual right of a partner who is held personally liable
for a partnership obligation to obtain indemnification from the partnership or contribution from
co-partners.714 It seems inconsistent with the Tex. LLP Stats. to allow a partner to recover,
directly or indirectly, from copartners who are shielded from liability by the same statutes, absent
a specific agreement of indemnification. Indeed, TRPA section 3.08(a) and TBOC section
152.801 expressly provide that a partner is not individually liable “by contribution, indemnity, or
otherwise” for partnership obligations except as otherwise provided. Quite apart from the Tex.
LLP Stats., there is authority that a partner who commits malpractice cannot recover from his or
her non-negligent copartners.715 It would certainly be inconsistent with the Tex. LLP Stats. to let
a plaintiff reach those co-partners through some theory of subrogation based on an alleged
indemnification or contribution right of the misfeasant partner.
7.
Inconsistent Partnership Agreement Provisions
A written or oral partnership agreement can modify or defeat the LLP liability shield. In
cases where a partnership agreement sets forth partner indemnification or contribution
obligations inconsistent with those described above,716 a creditor could argue that the partnership
711
712
713
714
715
716
TRLPA § 2.14; TBOC § 153.351.
TRLPA § 3.03; TBOC § 153.102.
TRLPA § 2.14(c); TBOC § 153.353.
TRPA § 3.08; TBOC § 152.801.
See, e.g., Flynn v. Reaves, 218 S.E.2d 661 (Ga. App. 1975).
Any LLP that intends by contract to require partners whose liabilities are shielded by the Tex. LLP Stats. to
indemnify or contribute to partners whose liability is not shielded (due to their own misconduct) should be
particularly sensitive to the “express negligence doctrine.” Under the “express negligence doctrine” as
articulated by the Supreme Court of Texas, an indemnification agreement is not enforceable to indemnify a
party from the consequences of its own negligence unless such intent is specifically stated in the agreement.
See Ethyl Corp. v. Daniel Constr. Co., 725 S.W.2d 705, 708 (Tex. 1987), wherein the Supreme Court held:
The express negligence doctrine provides that parties seeking to indemnify the
indemnitee from the consequences of its own negligence must express that intent in specific
terms. Under the doctrine of express negligence, the intent of the parties must be
specifically stated within the four corners of the contract. We now reject the clear and
unequivocal test in favor of the express negligence doctrine. In so doing, we overrule [prior
decisions] stating it is unnecessary for the parties to say, ‘in so many words,’ they intend to
indemnify the indemnitee from liability for its own negligence.
....
The contract between Daniel and Ethyl speaks to ‘any loss . . . as a result of operations
growing out of the performance of this contract and caused by the negligence or
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agreement supersedes the shield afforded by the Tex. LLP Stats.717 Thus, if a miscreant partner
is entitled to indemnification from the innocent partners in excess of the firm’s assets, then a
creditor could claim the indemnification right has become an asset of the miscreant partner’s
bankruptcy estate and the indemnification agreement could lead to a series of payments from the
innocent partners, with each payment ultimately being for the benefit of creditors entitled to
recover for the actions of the miscreant partner.718 The partnership could counter that
compliance with the Tex. LLP Stats. amends or otherwise trumps any inconsistent partnership
agreement provisions. Attorneys should exercise care to assure that the partnership agreement of
an LLP does not contain indemnification or contribution provisions that would inadvertently
frustrate the LLP purpose.
Since a partnership agreement may be written or oral,719 an LLP should have a written
partnership agreement that provides that it may be amended only by a written amendment.
Otherwise a creditor might argue that partner contributions to pay unshielded obligations (e.g.,
rent on a lease executed before September 1, 1997) constituted an amendment by conduct to the
partnership agreement that dropped the LLP liability shield.720
8.
Fiduciary Duties
Partners in an LLP are in a fiduciary relationship and owe each other fiduciary duties just
as in any other partnership. In Sterquell v. Archer,721 the court wrote:
No one disputed that Archer, Sterquell, and Harris were partners. As such, they
were involved in a fiduciary relationship which obligated each to act loyally
towards one another and to fully disclose information affecting the partnership
and their interests in same. [Citations omitted] So too were each prohibited from
personally taking advantage of information unknown to the others but concerning
partnership interests. Id. (each is a confidential agent of the other, each has a right
to know all that the others know). Furthermore, in violating any of these fiduciary
duties, the actor committed fraud. [Citations omitted]
9.
Foreign LLP Qualification
A foreign LLP doing business in Texas722 may qualify to do business in Texas like a
foreign LLC723 (the filing fee would be the lesser of $200 per resident partner724 or $750);
carelessness of [Daniel]. . . .’ Ethyl emphasizes the ‘any loss’ and ‘as a result of operations’
language to argue an intent to cover its own negligence. We do not find such meaning in
those words. The indemnity provision in question fails to meet the express negligence test.
See also Dresser Indus., Inc. v. Page Petroleum, Inc., 853 S.W.2d 505 (Tex 1993); Atlantic Richfield Co. v.
Petroleum Personnel, Inc., 768 S.W.2d 724 (Tex. 1989).
717
718
719
720
721
Bishop, The Limited Liability Partnership Amendments to the Uniform Partnership Act (1994), 53 BUS. LAW.
101, 118–20 (Nov. 1997).
See Banoff, “Alphabet Soup: A Navigator’s Guide,” 4 BUS. L. TODAY 10, 12 (1995).
TRPA § 1.01(12); TBOC § 151.001(4).
Bishop, supra note 717, at 120.
1997 WL 20881, 6 (Tex. App.—Amarillo 1997, no writ) (not designated for publication).
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722
Texas law does not define what constitutes “transacting business in Texas” for the purposes of the
requirement of TBOC section 152.905 (and the substantially similar TRPA section 10.02(a)) that “[b]efore
transacting business in this state, a foreign limited liability partnership must file an application for registration
in accordance with this section and Chapters 4 and 9.” TBOC section 9.251, however, does contain the
following non-exclusive list of activities not constituting transacting business in Texas:
Sec. 9.251.
Activities Not Constituting Transacting Business In This State.
For purposes of this chapter, activities that do not constitute transaction of
business in this state include:
(1)
maintaining or defending an action or suit or an administrative
or arbitration proceeding, or effecting the settlement of:
(A) such an action, suit, or proceeding; or
(B) a claim or dispute to which the entity is a party;
(2)
holding a meeting of the entity’s managerial officials, owners,
or members or carrying on another activity concerning the entity’s internal affairs;
(3)
maintaining a bank account;
(4)
maintaining an office or agency for:
(A) transferring, exchanging, or registering securities the entity
issues; or
(B) appointing or maintaining a trustee or depositary related to
the entity’s securities;
(5)
voting the interest of an entity the foreign entity has acquired;
(6)
effecting a sale through an independent contractor;
(7)
creating, as borrower or lender, or acquiring indebtedness or a
mortgage or other security interest in real or personal property;
(8)
securing or collecting a debt due the entity or enforcing a right
in property that secures a debt due the entity;
(9)
transacting business in interstate commerce;
(10)
conducting an isolated transaction that:
(A) is completed within a period of 30 days; and
(B) is not in the course of a number of repeated, similar
transactions;
(11)
in a case that does not involve an activity that would constitute
the transaction of business in this state if the activity were one of a foreign entity acting in
its own right:
(A) exercising a power of executor or administrator of the estate
of a nonresident decedent under ancillary letters issued by a
court of this state; or
(B) exercising a power of a trustee under the will of a
nonresident decedent, or under a trust created by one or
more nonresidents of this state, or by one or more foreign
entities;
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however, the failure of the foreign LLP to qualify would not affect its LLP shield in Texas.725
Under the Tex. LLP Stats., the laws of the state under which a foreign LLP is formed will govern
its organization and internal affairs and the liability of partners for obligations of the
partnership.726
Thus, under the Tex. LLP Stats., partners may choose the state law, and hence the
liability shield, that they wish to apply to their relationship.727 That choice should not be subject
to the general limitation in the Tex. GP Stats. that the law chosen by the partners to govern binds
only “if that state bears a reasonable relation to the partners or to the partnership business and
(12)
regarding a debt secured by a mortgage or lien on real or
personal property in this state:
(A) acquiring the debt in a transaction outside this state or in
interstate commerce;
(B) collecting or adjusting a principal or interest payment on the
debt;
(C) enforcing or adjusting a right or property securing the debt;
(D) taking an action necessary to preserve and protect the
interest of the mortgagee in the security; or
(E) engaging in any combination of transactions described by
this subdivision;
(13)
investing in or acquiring, in a transaction outside of this state, a
royalty or other non-operating mineral interest; or
(14)
the execution of a division order, contract of sale, or other
instrument incidental to ownership of a non-operating mineral interest.
See also TBOC § 153.903. The TRPA provides substantially the same. TRPA § 10.04.
723
724
See TRPA article X; TBOC Chapter 9 and §§ 152.901–.914 & 402.001(e).
The Secretary of State has adopted a regulation for determining whether a partner is in Texas for purposes of
annual fee calculations. TEX. ADMIN. CODE tit. 1, section 80.2(f) provides as follows:
(f) Partners in Texas. For purposes of this section, a partner is considered to be in Texas if:
(1) the partner is a resident of the state;
(2) the partner is domiciled or located in the state;
(3) the partner is licensed or otherwise legally authorized to perform the services of the
partnership in this state; or
(4) the partner, or a representative of the partnership working under the direct supervision
or control of the partner, will be providing services or otherwise transacting the business of
the partnership within the state for a period of more than 30 days.
(Emphasis added).
725
726
727
TRPA § 10.03(c); TBOC §§ 9.051, 152.910.
The TBOC places governance by foreign law into the very definition of “foreign”: “‘Foreign’ means, with
respect to an entity, that the entity is formed under, and the entity’s internal affairs are governed by, the laws
of a jurisdiction other than this state.” TBOC § 1.002(27). See also TBOC § 1.103. TRPA § 10.01 similarly
recognizes foreign governance of a foreign LLP’s internal affairs.
TRPA § 10.01; TBOC §§ 1.101–.105.
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affairs under principles that apply to a contract among the partners other than the partnership
agreement.”728
A determination of whether a foreign LLP must qualify to do business in any particular
state must be made on a state by state basis. A number of states, such as Delaware,729 do not
require such qualification, but recognize that the law governing the internal affairs of a
partnership also governs its liability to third parties. By contrast, New York and Maryland
require foreign LLPs to qualify to do business in the state.730
10.
Bankruptcy
Section 723 of the Bankruptcy Code731 addresses the personal liability of general partners
for the debts of the partnership, granting the trustee a claim against “any general partner” for the
full partnership deficiency owing to creditors to the extent that the partner would be personally
liable for claims against the partnership. In recognition of uncertainty as to how this provision
would be construed to apply with regard to LLPs which had been authorized by a number of
states since the advent of the 1978 Bankruptcy Code, the 1994 amendments to the Bankruptcy
Code clarified that a partner of an LLP would only be liable in bankruptcy to the extent that the
partner would be personally liable for a deficiency according to the LLP statute under which the
partnership was formed.732
11.
Federal Diversity Jurisdiction
An LLP is a citizen of every state in which one of its partners resides for the purposes of
Federal court diversity jurisdiction.733 As a result, large accounting firms with offices in most
states are likely beyond the reach of the diversity jurisdiction of the Federal courts.734
VII.
EXTRATERRITORIAL RECOGNITION OF LLC AND LLP LIMITED
LIABILITY
A.
728
729
730
731
732
733
734
General
TRPA § 1.05(a)(1). See TBOC § 1.002(43)(C)(i), providing substantively the same. See also TEX. BUS. &
COM. CODE § 35.51.
DEL. CODE ANN., tit. 6, §§ 1515, 1547 (1999 & Supp. 2002).
N.Y. P’SHIP LAW § 121-1502 (McKinney Supp. 2006); MD. CODE ANN. CORPS. & ASS’NS § 9A-1101 (1999).
11 U.S.C. § 723, as amended by Pub.L. 103-394, Title II, § 212, Oct. 22, 1994, 108 Stat. 4125 (the
“Bankruptcy Code”).
Congressional Record—House H 10767 (Oct. 4, 1994). This amendment to the Bankruptcy Code is
attributable in large part to efforts of representatives of the Texas Business Law Foundation.
Reisman v. KPMG Peat Marwick LLP, 965 F. Supp. 165 (D. Mass. 1997), relying on Carden v. Arkoma
Assoc., 494 U.S. 185 (1990).
The court in Reisman wrote that it was “particularly troubled that a Big Six accounting firm which operates
offices within every state in the United States has effectively immunized itself from the reach of the diversity
jurisdiction of the federal courts simply by organizing itself as a limited liability partnership rather than a
corporation. Nevertheless, until Congress addresses the jurisdictional implications of this new class of
business entities, this Court can reach no other result.”
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Courts of other states should recognize the Texas statutory liability shield of LLCs and
LLPs under the “internal affairs” doctrine, which treats the laws of the state of organization as
governing the liability of members of business organizations, such as corporations and limited
partnerships.735 The principal case that did not follow this doctrine was a Texas case, which has
been effectively overturned by H.B. 278. The extent to which LLC or LLP status will be
recognized in other jurisdictions absent a specific statute, however, remains a question for which
there is little case-law precedent.736
B.
Texas Statutes
The LLC Act states that it is the “intention of the legislature by the enactment of this Act
that the legal existence of limited liability companies formed under this Act be recognized
beyond the limits of this state and that, subject to any reasonable registration requirements, any
such limited liability company transacting business outside this state shall be granted the
protection of full faith and credit under Section 1 of Article IV of the Constitution of the United
States.”737
There is no comparable statement of legislative intention in the Tex. LLP Stats.
However, they do provide that (1) a partnership’s internal affairs are governed by the law of the
state chosen by the partners if the law chosen bears a reasonable relationship to the partnership’s
business and affairs under applicable choice of law principles and (2) the law governing a
partnership’s internal affairs also governs the liability of its partners to third parties.738 Texas has
thus codified the internal affairs doctrine recognized by the courts of other states, as discussed
below.
C.
Texas Cases
Texas appears to be the only state with a reported decision denying limited liability to
owners of an unincorporated entity formed under another state’s law because the forum state did
not have such a statute.739 In Means v. Limpia Royalties,740 suit was brought in Texas by a
purchaser of trust interests for rescission of the purchase because of misrepresentations by the
735
736
737
738
739
740
TBOC § 1.101–.105; cf. Revised Uniform Limited Partnership Act § 9.01 adopted in many states and in this
state as TRLPA § 9.01(a); TBCA art. 8.02; 59A Am. Jur. 2d Partnership § 30 (1987); 29 A.L.R. 2d 295
(1953). For a discussion of the history of TBCA art. 8.02, see R. Dennis Anderson and Harva R. Dockery,
“Formalities of Corporate Operations,” Texas Corporations—Law and Practice § 31.05 (1986).
See Herbert B. Chermside, Jr., Annotation, Modern Status of the Massachusetts or Business Trust, 88 A.L.R.
3d 704 (1978) (“In some jurisdictions a Massachusetts or business trust has been treated as a partnership for
some purposes.”).
LLC Act § 4.03B.
TRPA § 1.05; TBOC §§ 1.101–.105.
Commentators generally suggest that uncertainty as to whether the statutory limited liability of Members will
be recognized in a jurisdiction other than the jurisdiction of the LLC’s organization is a drawback to using an
LLC for a business with operations in more than one state, but the only authorities cited for that concern are
the Texas cases discussed herein. See, for example, Lederman, “Miami Device: The Florida Limited Liability
Company,” 67 TAXES 339, 342 (June 1989); and Roche, Keatinge and Spudis, “Limited Liability Companies
Offer Pass—Through Benefits Without S Corp. Restrictions,” 74 J. TAX’N 248, 253 (April 1991).
115 S.W.2d 468, 475 (Tex. Civ. App.—Ft. Worth 1938, writ dism’d).
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5030707v.1
defendant that holders of trust interests could not be liable for trust obligations. Limpia
Royalties was an unincorporated association operating under a declaration of trust, was
organized under the laws of Oklahoma and had its principal office in Oklahoma. In holding that
the representations were materially misleading, the court wrote:
It is well settled in this state by a long line of decisions that a shareholder
in an unincorporated or joint-stock association is liable to its creditor for debts of
the association; his liability being that of a partner. 25 Tex. Jur. section 20, p.
202, and authorities there cited.
The fact that, under the laws of the state of Oklahoma and under the
provisions of the declaration of trust, a shareholder in the Limpia Royalties could
not be held liable for the debts or obligations of the association would not operate
to extend the same immunity from liability growing out of transactions by the
association in the state of Texas, since, as is well said in the opinion in Ayub v.
Automobile Mortgage Company, 252 S.W. 287, 290 [(Tex. Civ. App.—El Paso
1923, writ granted) rev’d. Auto. Mortgage Co. v. Ayub, 266 S.W. 134 (Tex.
Comm’n. App. 1924)]. “The established public policy of the forum is supreme,
and will not be relaxed upon the ground of comity to enforce contracts which
contravene such policy, even though such contracts are valid where made.”741
741
115 S.W.2d at 475. The Limpia Royalties case was cited and its rationale followed in Cherokee Village v.
Henderson, 538 S.W.2d 169, 173 (Tex. Civ. App.—Houston 1976, writ dism’d), a personal injury case in
which the property on which the injury occurred was held pursuant to a trust agreement. The trust agreement,
which apparently was governed by Texas law, recited that no partnership was intended and that no party had
any right to incur any liability on account of any other party. The defendants in the case were holders of
beneficial interests in the trust, which was a successor to a general partnership in which the holders had been
partners. Two years after the creation of the trust, but two years prior to the injury, three individuals withdrew
from the arrangement by a document which purported to be an amendment to the venture’s “agreement of
general partnership” and an assumed name certificate was filed in which the defendants were listed as general
partners. The court was not persuaded by the defendants’ testimony that these actions were erroneous. In
holding that the defendants were liable and that the trust was a partnership under Texas law, the court wrote:
Article 6132b, the Texas Uniform Partnership Act, Section 6, defines a partnership as “an
association of two or more persons to carry on as co-owners a business for profit.” Section
7 of this Act sets forth certain criteria for determining the existence of a partnership under
the Act. Under this section it is provided that with the exception of certain circumstances
not here existent, the receipt by a person of a share of the profits of a business is prima facie
evidence that he is a partner of the business. TEX. REV. CIV. STAT. ANN. art. 6132a, the
Texas Uniform Limited Partnership Act, sets forth the method by which limited partners,
who do not wish to be bound by the obligations of the partnership, may carry on a business
as a limited partnership. TEX. REV. CIV. STAT. ANN. art. 6138a sets forth the requirements
for creation of a Real Estate Investment Trust. Section 8 of that Act provides for limited
liability of the shareholders of such a trust. Appellants here do not contend that there was
compliance with the requisites of either of these statutes.
Where two or more persons associate themselves as co-owners of a business for profit they
become jointly and severally responsible for obligations incurred in the conduct of such
business unless they have established, under some applicable statute, an association which
the law recognizes as providing limited personal liability.
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The sections of the Tex. LLC Stats. providing for qualification of Foreign LLCs were
intended to repudiate, and resolve the concern raised by, the Limpia Royalties case with respect
to limited liability of non-corporate entities created under the laws of other states but not
authorized to be created under Texas law.742 The Bill Analysis743 used by the Legislature in
connection with the consideration of H.B. 278 states:
The provisions of Part 7 providing for the qualification of foreign Limited
Liability Companies is intended to eliminate the concern raised by Means v.
Olympia [sic] Royalties, 115 S.W.2d 468 (Tex. Civ. App.—Ft. Worth 1938 [writ
dism’d]), as to whether a Texas court would honor the limitation of liability of a
foreign business entity. Moreover, the definition of “Foreign Limited Liability
Company” is sufficiently broad to provide for the qualification of any business
entity affording limited liability, not entitled to qualify under another statute,
whether or not characterized as a limited liability company.744
742
743
744
H.B. 278 § 46 Part Seven. Prior to the enactment of H.B. 278, Texas was already firmly committed by statute
to the internal affairs doctrine for both corporate and non-corporate business organizations. The 1977
amendment to Texas Uniform Limited Partnership Act, art. 6132a § 32(c) specified that, in the case of a
foreign limited partnership qualified in Texas, “its internal affairs and the liability of its limited partners shall
be governed by the laws of the jurisdiction of its formation.” That principle is carried forward in Texas
Revised Limited Partnership Act, art. 6132a-1 § 9.01(a): “The laws of the state under which a foreign limited
partnership is formed govern its organization and internal affairs and the liability of its partners” (whether or
not the foreign limited partnership is registered to do business in Texas). The 1989 amendment to Texas
Business Corporation Act art. 8.02 prescribes that “only the laws of the jurisdiction of incorporation of a
foreign corporation shall govern (1) the internal affairs of the foreign corporation . . . and (2) the liability, if
any, of shareholders . . .” The TBOC provides substantively the same. TBOC §§ 1.002(27), (28), 1.102–.105.
Bill Analysis of H.B. 278 by Wolens at 10 (1991). See 1991 Bill Analysis Summary at 41.
“Foreign Limited Liability Company” is broadly defined in LLC Act section 1.02(9) as follows:
(9) “Foreign Limited Liability Company” means an entity formed under the laws
of a jurisdiction other than this state (a) that is characterized as a limited liability company
by such laws or (b) although not so characterized by such laws, that elects to procure a
certificate of authority pursuant to Article 7.01 of this act, that is formed under laws which
provides [sic] that some or all of the persons entitled to receive a distribution of the assets
thereof upon the entity’s dissolution or otherwise or to exercise voting rights with respect to
an interest in the entity shall not be liable for the debts, obligations or liabilities of the entity
and which is not authorized to qualify to do business in this state under any other statute.
See also discussion supra Part V. R.—Foreign LLCs and TBOC §§ 9.001–.003.
H.B. 278 section 46 art. 7.02 provides in relevant part as follows with respect to a foreign limited liability
company that has procured a certificate of authority from the Secretary of State to transact business in Texas
pursuant to H.B. 278 section 46 Part Seven:
. . . only the laws of the jurisdiction of organization of a foreign limited liability company
shall govern (1) the internal affairs of the foreign limited liability company, including but
not limited to the rights, powers, and duties of its manager and members and matters
relating to its ownership, and (2) the liability, if any, of members of the foreign limited
liability company for the debts, liabilities and obligations of the foreign limited liability
company for which they are not otherwise liable by statute or agreement.
See also TBOC §§ 1.104–.105.
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D.
Decisions in Other States
There is precedent in other jurisdictions suggesting that their courts would apply the
internal affairs doctrine to unincorporated entities not organized or qualified to do business as
foreign entities under local law, thus preserving the liability shield of Texas law for LLCs and
LLPs. Further, there apparently are no reported cases in other jurisdictions that follow the
reasoning of, or reach the same result as, the Limpia Royalties case.
This issue of which jurisdiction’s law governs liabilities of partners to third parties arose
in King v. Sarria, an 1877 New York case of first impression.745 The defendants entered into a
contract of partnership in Cuba, which was then ruled by Spanish law. Under the contract,
defendant Sarria became a special partner whose liability was expressly limited to a fixed
amount. As a special partner under Spanish law, Sarria was entitled to participate in the profits
of the partnership, but could not be made liable for its debts. The plaintiffs sought to recover
from Sarria a sum of money due under a contract with the partnership.
The court held that the partnership agreement was governed by the laws of Spain746 and
that the liability of Sarria and the extent of the authority of his partners to bind him747 were to be
determined by those laws. The court stated:
[W]here the essentials of a contract made under foreign laws are not hostile to the
law and policy of the State, the contract may be relied upon and availed of in the
745
746
747
King v. Sarria, 69 N.Y. 24 (Ct. of App. 1877).
Where a partnership is formed under the laws of a particular state and there is no conflicting choice of law
provision in the agreement, it is as if the partners have implicitly agreed to be bound by the laws of that state.
See Rogers v. Guaranty Trust, 298 U.S. 123 (1933); Seidman & Seidman v. Wolfson, 123 Cal. Rptr. 873 (Cal.
Ct. App. 1975) (California court held that New York law should determine the rights and obligations among
partners in an accounting firm where the partnership agreement so provided); Hill-Davis Co. v. Atwell, 10
P.2d 463 (Cal. 1932) (a court will generally refer to the law of the state of the entity’s organization to
determine the precise nature of the powers or qualities enjoyed by such entity); Gilman Paint & Varnish v.
Legum, 80 A.2d 906, 29 A.L.R. 2d 236 (Md. 1951) (the liability to third persons of a partner with limited
liability is an issue to be determined under Maryland law where the partners were all from Maryland, the
partnership agreement was made in Maryland, it was a Maryland partnership in its inception and no
representations were made otherwise); Froelich & Kuttner v. Sutherland, 22 F.2d 870 (D.C. 1927) (where
entity was organized under Philippine statutes, that country’s laws determined whether the organization was a
general partnership, limited partnership or a corporation).
The court in King v. Sarria noted that, since the contract in question was made by persons other than Sarria,
the plaintiff had to show that the other partners had authority to bind Sarria and that the plaintiff was relying
upon the mutual general agency which results from the relation of partnership to show that authority. The
court noted that, if the Spanish statute were not applicable, the plaintiff would prevail “for by virtue of the
relationship of partnership, one partner becomes the general agent for the other, as to all matters within the
scope of the partnership dealings, and has thereby given to him all authority needful for carrying on the
partnership, and which is usually exercised by partners in that business” and “that any restriction which by
agreement amongst the partners is attempted to be imposed upon the authority, which one partner possesses as
the general agent of the other, is operative only between the partners themselves, and does not limit the
authority as to third persons . . . unless they know that such restriction has been made.” Sarria, 69 N.Y. at 28–
29. The court noted that the foregoing common law principles, which are comparable to TUPA sections 9, 13,
14 and 15(1) (without the LLP exception), were qualified by the provisions of any applicable statute providing
for the formation of partnerships with limited liability.
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courts of this State. If the substance of the contract is against that law and policy,
our judicatories will refuse to entertain it and give it effect.748
In King v. Sarria, the court held that the Spanish statute limiting liability of particular
partners was not contrary to New York public policy and therefore applied the Spanish statute to
limit Sarria’s liability.749 However, in reaching this conclusion, the court noted that the Spanish
statute resembled New York’s own statute for the formation of limited partnerships.750
The 1982 New York case of Downey v. Swan751 helps answer the question of what
happens when the forum state has no corresponding statute. In Downey, the defendant Swan was
a member of a limited partnership association formed under New Jersey law. Under New Jersey
law, the members and managers of a limited partnership association were not personally liable
for a wrongful death that occurred on property owned by the partnership. In remanding the case
to the trial court for a determination whether the association was operating after its term had
expired, the court held that if the association were still in existence, the liabilities of its members
would be governed by New Jersey law and the limited liability afforded by that law would be
given full effect.752 Because New York had no limited partnership association law, the New
York court could not have applied analogous New York law to reach the same result.753
In a case involving a Texas LLP law firm, the internal affairs doctrine was recognized by
a federal district court in Massachusetts. In Liberty Mutual Insurance Co. v. Gardere & Wynne,
L.L.P.,754 although the court granted a motion to transfer a case to a federal court in Texas
largely to avoid having to decide numerous questions about the effect of the Texas LLP status755
748
749
750
751
752
753
754
755
Sarria, 69 N.Y. at 34.
For a contract to be void as against New York public policy, it must be quite clearly repugnant to the public
conscience. See Kloberg v. Teller, 171 N.Y.S. 947, 948 (Sup. Ct. Bronx Co. 1918).
The court indicated that the same reasoning would apply to contract and tort claims.
Downey v. Swan, 454 N.Y.S. 2d 895 (A.D. 2d Dep’t 1982).
Cf. Schneider v. Schimmels, 64 Cal. Rptr. 273 (1967) (California court permitted recovery for loss of
consortium pursuant to a Colorado statute although California did not have a similar statute granting such
damages).
Cf. Abu-Nassar v. Elders Fututes, Inc., No. 88-Civ. 7906, U.S. Dist. LEXIS 3794 (S.D.N.Y. Mar. 28, 1991),
in which an LLC organized under Lebanese law was treated as though it were a foreign corporation for
purposes of analyzing choice of law and veil piercing liability.
Liberty Mutual Insurance Co. v. Gardere & Wynne, L.L.P., 1994 WL 707133, Civ. A. No. 94-10609-MLW
(D. Mass. Dec. 6 1994).
Liberty Mutual Ins. Co. v. Gardere & Wynne, L.L.P. involved claims of breach of fiduciary duty and conflict
of interest asserted by Liberty Mutual Insurance Company (“Liberty”) against the Dallas based law firm of
Gardere & Wynne, L.L.P. (“Gardere”), which had represented Liberty for many years. Gardere was a Texas
partnership that had taken the steps to become a registered LLP under the TRPA. Two Gardere lawyers,
Nabors and Woods, also were defendants in the suit; Nabors clearly was a partner in Gardere, but the facts
were uncertain about whether Woods’s election to “income partner” status had been given effect before he left
Gardere to join another firm. Liberty filed its suit in the federal district court in Massachusetts, where its
principal office was located. Gardere, Nabors, and Woods moved for dismissal or, alternatively, to have the
case transferred to Texas.
Gardere’s motion to dismiss was based upon Massachusetts law providing that a general partnership could not
be sued in its common name but that, instead, suit must be brought against each of the partners individually.
The individual defendants’ motions to dismiss were based upon a claimed lack of personal jurisdiction over
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on a case pending in Massachusetts which did not have an LLP statute, the limited liability of
partners under the Tex. LLP Stats. was recognized under the internal affairs doctrine as follows:
The court assumes that, if this case were tried in a state or federal court in
Massachusetts, the court would look to Texas substantive law to determine the
liability of partners in a Texas RLLP for debts arising out of claims for breach of
fiduciary duty by other partners. See Mass.Gen.L. ch. 109, section 48 (liability of
limited partners of a foreign limited partnership “shall be governed by the laws of
the state under which it is organized”); Klaxon v. Stentor Elec. Mfs. Co., 313 U.S.
487, 496 (1941) (federal court in diversity case applies choice of law principles of
Nabors and Woods by a court located in Massachusetts. Both of these asserted grounds for dismissal would
be moot if the case were transferred to Texas, because Texas law permits a partnership to be sued in its
common name, and Nabors and Woods clearly were subject to the personal jurisdiction of a court sitting in
Texas.
Massachusetts had no counterpart to the Texas LLP statute. The court observed that, if it undertook to
consider the motions to dismiss, its analysis would be complicated the fact that Gardere was not a general
partnership “in the traditional sense familiar to Massachusetts judges and lawyers.” The court identified
numerous procedural and substantive questions emanating from the uncertainty of Gardere’s organizational
status under Massachusetts law, including the following issues:
(1)
Whether, for Massachusetts law purpose, Gardere was a limited partnership;
(2)
If Gardere was a limited partnership, whether suit could be brought against it by naming
only its general partners as defendants;
(3)
If Gardere was a limited partnership and could be sued by naming only its general partners,
whether the “general partners” were only those partners who, under TRPA, could be liable
for the alleged breaches of duty claimed by Liberty;
(4)
Whether the breaches of duty alleged by Liberty were the type of “errors, omissions,
negligence, incompetence, or malfeasance” enumerated in TRPA for which a registered
LLP member’s liability was limited to cases of direct involvement or failure to prevent
errors and omissions;
(5)
With respect to the individual defendants’ claims of lack of personal jurisdiction, whether
certain Gardere partners who had actually visited Massachusetts from time to time had been
agents of other Gardere partners, by operation of general partnership law;
(6)
Whether such presence by other Gardere partners constituted agency on behalf of the
individual defendants when it occurred prior to the individual defendants’ joining the
Gardere firm; and
(7)
If such agency occurred, whether it was effective with respect to an “income partner” such
as Woods, who did not have an equity interest or many of the rights held by equity partners
(assuming Woods actually became an income partner).
The court concluded that, despite the deference normally accorded to a plaintiff’s choice of forum, the
complicated issues stemming from Gardere’s uncertain legal status under Massachusetts law, combined with
the fact these issues would be moot if the case were transferred to Texas, compelled the court to transfer the
litigation to a federal district court sitting in Texas. The court thus saved itself from resolving the many issues
it had identified that were produced by the incompatibility of Texas and Massachusetts partnership law by
transferring the case to Texas.
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state in which federal court is located). Thus, Texas law will apply to this
question whether or not the case is transferred.756
The Gardere case illustrates the difficult procedural issues which can be encountered
when liability is asserted against an LLC or an LLP outside of the jurisdiction of its creation.
Under general conflict of law principles, (i) for contract claims, in the absence of a valid
contractual choice of law provision, the law of the jurisdiction with the most significant contacts
will govern, and (ii) for tort claims, the law of the state with the most significant relationship to
the occurrence and the parties will generally govern.757 Whether a court adjudicating a claim
against a foreign LLC or LLP, after applying one state’s laws in determining that an LLC or LLP
is liable for a contract or tort claim, will then apply the internal affairs doctrine or the full faith
and credit clause of the Constitution to uphold the liability shield of the entity’s jurisdiction of
organization remains an issue in those few jurisdictions still lacking statutory guidance, although
the better authority to date would apply the internal affairs principle and uphold the statutory
liability shield.
E.
Qualification as Foreign Entity and Other Ways to Reduce Extraterritorial
Risk
Since all 50 states (including Texas) plus the District of Columbia now have LLC
statutes, the LLC extraterritorial risk analysis requires analysis of the applicable LLC statute in
each of the states in which the LLC contemplates doing business. Generally qualification as a
foreign LLC in a jurisdiction will protect Members’ limited liability, but failure to qualify may
not result in the loss of limited liability, although it may result in the imposition of statutory
penalties. The LLC statutes in Texas, New York and Delaware, which each contain provisions
for the registration/qualification of foreign LLCs, expressly provide that the failure of a foreign
LLC to so qualify shall not affect the limited liability of its members or managers, which shall be
determined by the laws of the LLC’s jurisdiction of organization.758 Likewise, since all states
plus the District of Columbia have LLP statutes, foreign qualification needs to be considered as a
means of reducing extraterritorial risk for LLPs. Delaware, New York, and Maryland all provide
for foreign qualification.759
756
757
758
759
Gardere & Wynne, 1994 WL 707133 at *6 n.7.
Miller, Procedural and Conflict of Laws Issues Arising In Connection With Multi-State Partnerships, ABA
BUS. L. SEC. (1996).
LLC Act §§ 7.01–.02; N.Y. LLC Law §§ 801–802 (2006); 6 DEL. CODE §§ 18-901–18-902 (2006). N.Y.
LLC Law section 802 further provides that within 120 days after the filing of its application for authority,
the foreign LLC must publish once each week for six successive weeks in one daily and one weekly
newspaper (each designated by the county clerk in the county where the LLC is located) generally the same
information required to be filed with the New York Department of State and must file a proof of
publication with the New York Department of State, and failure to file such proof of publication will result
in automatic suspension of the LLC’s right to transact business in New York.
DEL. CODE ANN. tit. 6 § 15-1101 et seq (2005); N.Y. P’SHIP LAW § 121-1502 (McKinney 1998 & Supp. 2006);
MD. CODE ANN., CORPS. & ASS’NS § 9A-1101 (1999). N.Y. P’SHIP LAW § 121-1502 (McKinney 1998 &
Supp. 2006) further provides that within 120 days after the filing of its application for authority, the foreign
LLP must publish once each week for six successive weeks in one daily and one weekly newspaper (each
designated by the county clerk in the county where the LLP is located) generally the same information
required to be filed with the New York Department of State and must file a proof of publication with the
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5030707v.1
Although the LLP is the entity of choice for many professionals, not all states permit all
types of professionals to avail themselves of limited liability for professional malpractice
(whether through a professional corporation, a PLLC or an LLP), thus necessitating additionally
a review of the applicable professional rules in each jurisdiction in which the entity proposes to
transact business.760
VIII. DECISION MATRIX
Key elements in deciding among business entities are (1) how the entity will be taxed and
(2) who will be liable for its obligations. The entity itself will always be liable to the extent of its
assets, so the question is who will be liable, if anyone, if the entity’s assets are not sufficient to
satisfy all claims. These two considerations tend to receive the principal focus in the entity
choice decision, although management, capital raising, interest transferability, continuity of life
and formation issues such as cost and timing can be critical in many cases.
If the owners are content to pay federal income taxes at the entity level and then pay
taxes on earnings distributed to them, the choice is easy — regular business corporation without
an S-corporation election.
If the owners do not want the entity’s earnings to be taxed twice, the entity selection
process becomes more complicated and the choices are:
•
•
•
•
•
General partnership
LLP
Limited partnership
LLC
S-corporation
A.
If limited liability of the owners is unimportant and all of them are individuals,
the choice is a general partnership in which partners are jointly and severally liable for all
partnership liabilities.
B.
If the owners are willing to accept liability for their own torts but want to avoid
liability for contracts and torts of other partners for which they have no culpability and are
willing to risk being subject to the Margin Tax, the LLP becomes the entity of choice.
C.
The limited partnership will provide tax flow through without the S-corporation
restrictions discussed below, with no self-employment tax on income of limited partners, and
with limited liability for limited partners, but has its own limitations:
1.
760
must have a general partner which is liable for all partnership
obligations—contract and tort—but under Check-the-Box Regulations,
New York Department of State, and failure to file such proof of publication will result in automatic
suspension of the LLP’s right to transact business in New York.
See Rogers, Questions of Law and Ethics Face Firms Becoming LLPs, LLCs, 12 ABA/BNA LAWYERS’
MANUAL OF PROF’L CONDUCT 411 (No. 23 Dec. 11, 1996); Meyer v. Okla. Alcoholic Laws Enforcement
Comm’n., 890 P.2d 1361 (Okla. Ct. App. 1995) (finding that an LLC is not permitted to hold liquor license).
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capitalization of general partner is not important and a limited partnership
can elect to also be an LLP which has the effect of limiting the liability of
the general partner
2.
limited partners who participate in management of business may become
liable as general partners, but statutes generally allow a degree of
participation and no liability unless reliance upon the limited partner as a
general partner
3.
effective for tax years beginning on or after January 1, 2007, the Margin
Tax is imposed on LLPs, although the LLP is a species of general
partnership to which the Margin Tax generally is not applicable.761
D.
The LLC can be structured to have tax flow through and limited liability of Scorporation or limited partnership without any of their drawbacks, but:
(i)
effective for tax years beginning on or after January 1, 2007, the Margin
Tax has replaced the Texas franchise tax and is imposed on LLCs.762
(ii)
self-employment tax issues
(iii)
questions regarding
•
•
state income taxation issues
the extent to which other states will recognize statutory limitation
of Members’ liability and the related questions of whether/how to
qualify as a foreign LLC
E.
The S-corporation will give limitation of owner liability and federal income tax
flow through (even when there is only one owner), but an S-corporation is subject to the Texas
Margin Tax, and there are limitations on its availability under the IRC. S-corporation status is
not available where the entity:
1.
has more than 100 equity holders;
2.
has more than one class of stock;
3.
has among its shareholders any:
•
•
•
•
761
762
general or limited partnership
trust (certain exceptions)
non resident alien
corporation (exception for “qualified subchapter S subsidiary”).
See discussions supra Part I. General—E. Texas Entity Taxation—3. Margin Tax and Part I. General—E.
Texas Entity Taxation—4. Constitutionality of Margin Tax.
See discussion supra Part I. General—E. Texas Entity Taxation—3. Margin Tax.
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5030707v.1
TAX COSTS IN CHOICE OF ENTITY DECISION
The following chart compares the taxes that would be paid by different entities and their owners
based on assumed gross receipts, gross margin and net income in 2008. In each case, the entity
is assumed to have (i) $1,000 of gross revenue, (ii) $700 of gross margin for Margin Tax
purposes, which would be the maximum taxable margin under Tex. Tax Code
section 171.101(a)(1) and all of which is apportioned to Texas under Tex. Tax Code
section 171.101(a)(2), and (iii) $100 of net income that is of a type subject to self-employment
taxes (i.e., is income from a trade or business) and is distributed (after taxes) to its owners. It is
also assumed that the owners will have earned income or wages in excess of the base amount for
the tax year and will therefore be subject to only the 2.9% Medicare tax (and not the 12.40%
social security equivalent tax to a base of $102,000 in 2008).
Item
S-Corp or
Limited Liability
Company(a)
C-Corporation
Entity Level
Total Revenue
General Partner in
General or
Limited Partnership(a)
Limited Partner in
Limited
Partnership(a)
1,000.00
1,000.00
1,000.00
1,000.00
Taxable Margin
700.00
700.00
700.00
700.00
Net Income
100.00
100.00
100.00
100.00
7.00
7.00
7.00
7.00
Taxable Income of Entity
93.00
93.00
93.00
93.00
Fed. Income Tax (at 35%)
32.55
0
0
0
Income After Taxes(c)
60.45
93.00
93.00
93.00
60.45
93.00
93.00
93.00
0
2.90(d)
2.90
0
60.45
(e)
(e)
93.00
31.54
31.54
32.55
58.56
58.56
60.45
Margin Tax (b)
Owner Level
Distribution & Share of Income
Self-Employment Tax
Taxable Income of Owner
Fed. Income Tax On
Dividends (at 15%)
90.10
9.07
Fed. Tax On Income
Allocation (at 35%)
Amount Received After Taxes
90.10
51.38
_______________
(a)
Assumes that (i) the entity is treated as a partnership for federal income tax purposes and (ii) one of its owners is a business entity.
(b)
Assumes that (i) Margin Tax is applicable since gross receipts are all in 2008, (ii) the gross margin for Margin Tax purposes is $700,
which would be the maximum taxable margin under Tex. Tax Code section 171.101(a)(1), and all of it is apportioned to Texas under
Tex. Tax Code section 171.101(a)(2), and (iii) the applicable Margin Tax rate is 1% (the rate is 0.5% for a narrowly defined group of
retail and wholesale businesses). Under Tex. Tax Code section 171.101(a)(1) a taxable entity’s taxable margin is the lesser of (x) 70%
of its total revenue or (y) an amount determined by subtracting from its total revenue either its cost of goods sold or its compensation
paid as elected or deemed elected pursuant to the Tex. Tax Code. See discussion supra Part I. General—E. Texas Entity Taxation—3.
Margin Tax.
(c)
Post Margin Tax, the income after taxes of most entities is the net income of the entity less the Margin Tax and, in the case of the
C-corporation, the applicable federal income taxes.
(d)
A non-managing member of an LLC may not be subject to the self-employment tax; a shareholder of an S-corporation is not subject to
self-employment tax on actual or constructive dividends but would be subject to self-employment tax on compensation received.
(e)
One-half of the self-employment tax is deductible against the individual’s income for federal income tax purposes.
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5030707v.1
IX.
CONCLUSION
There are several entity forms to consider when organizing a business in Texas. The
characteristics of each, which are discussed above and are tabulated on the Entity Comparison
Chart attached as Appendix A, will influence the choice among the entities for a particular
situation.
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5030707v.1
Appendix A
ENTITY COMPARISON CHART
Note: Chart reflects requirements and allowances from the TBOC, not from source law which may apply to some entities until January 1, 2010.
Item
Sole
Proprietorship
General
Partnership
Limited
Liability
Partnership
Limited
Partnership
Limited
Liability
Company
“C” Corp.
“S” Corp.
Limited liability
of owners for
entity obligations
Name
No
No
Yes
Yes
Yes
Yes
Yes
No Requirements
No Requirements
L.L.P. must
contain “Limited
Liability
Partnership” or
an abbreviation
thereof.
Must contain
“Limited
Partnership,”
“Limited,” or an
abbreviation of
either.
Must contain
“Limited
Liability
Company,”
“Limited
Company,” or an
abbreviation of
either (unless
formed prior to
September 1,
1993 in
compliance with
the laws then in
effect).
Must contain
“Corporation,”
“Company,”
“Incorporated,”
“Limited,” or an
abbreviation of
any of these.
Must contain
“Corporation,”
“Company,”
“Incorporated,”
“Limited,” or an
abbreviation of
any of these.
Filing
Requirements
Assumed Name
Certificate Filing
and Payment of
Applicable Filing
Fees
Assumed Name
Certificate Filing
and Payment of
Applicable Filing
Fees
Certificate of
Formation and
Filing Fee of $750
Certificate of
Formation and
Filing Fee of $300
Certificate of
Formation and
Filing Fee of $300
Certificate of
Formation and
Filing Fee of $300
Ownership Types
No. of Owners
Individuals
One
Any
Minimum of 2
Annual
Registration and
Filing Fee of $200
per Partner; Must
Maintain Liability
Insurance or Meet
Alternative
Financial
Responsibility Test
Any
Minimum of 2
Any
Minimum of 2
Any
No Restrictions
Limited
No More than 100
Professionals
Yes
Yes
Yes
Yes
Any
Single Member
LLCs Permitted in
Texas
Yes
Yes, But Generally
Governed By
Yes, But Generally
Governed By
Appendix A – Page 1
5030707v.1
Item
Sole
Proprietorship
General
Partnership
Limited
Liability
Partnership
Ownership Classes
One
Multiple Classes
Allowed
Multiple Classes
Allowed
Transferability of
Interests
Freely Transferable
Economic Interest
is Transferable
Unless Restricted
by Partnership
Agreement;
However, the
Status of Partner is
not Transferable
Without Consent of
All Partners
Economic Interest
is Transferable
Unless Restricted
by Partnership
Agreement;
However, the
Status of Partner is
not Transferable
Without Consent of
All Partners
Limited
Partnership
Multiple Classes
Allowed but Must
Have at Least 1
General Partner
and 1 Limited
Partner.
Economic Interest
is Transferable
Unless Restricted
by Partnership
Agreement;
However, the
Status of Partner is
not Transferable
Without Consent of
All Partners
Appendix A – Page 2
5030707v.1
Limited
Liability
Company
Multiple Classes
Allowed
Economic
Membership
Interest Freely
Transferable
Unless Restricted
by Articles of
Organization or
Regulations;
However, Unless
Otherwise
Provided in
Articles of
Organization or
Regulations, the
Status of Member
is Not Transferable
Without Consent of
All Members
“C” Corp.
“S” Corp.
TBOC Title 7
Professional
Entities if There is
Conflict With
TBOC Title 2
Corporations. For
Entities Existing
Prior To January 1,
2006, Generally
Governed By
Texas Professional
Corporation Act or
Texas Professional
Association Act
Multiple Classes
Allowed
TBOC Title 7
Professional
Entities if There is
Conflict With
TBOC Title 2
Corporations. For
Entities Existing
Prior To January 1,
2006, Generally
Governed By
Texas Professional
Corporation Act or
Texas Professional
Association Act
Limitation as to 1
Class of Stock
Freely Transferable
Unless Restricted
by Articles of
Incorporation,
Bylaws or
Shareholder
Agreement
Freely Transferable
Unless Restricted
by Articles of
Incorporation,
Bylaws or
Shareholder
Agreement
Appendix B
Basic Texas Business Entities
and
Federal/State Taxation Alternatives Chart
Texas Law Entity
Check-the-Box
Federal Taxation
TX Franchise
Tax until
1/1/07763
TX Margin
Tax 1/1/07
Proprietorship
Not Applicable
Form 1040, Schedule C or E
None
None
LLC / single individual
member
LLC / single entity
member
General Partnership or
LLP
General Partnership or
LLP
Limited Partnership
Disregarded764
Form 1040, Schedule C or E
(Proprietorship)
Yes
Yes
Yes
Yes
Disregarded2
Division of Member Entity
Partnership765
Partnership
None
Depends
Corporation
C or S-Corp766
None
Depends
Partnership3
Partnership
None
Yes
Limited Partnership
Corporation
C or S-Corp4
None
Yes767
LLC / multi-members
Partnership3
Partnership
Yes
Yes5
LLC / multi-members
Corporation
C or S-Corp4
Yes
Yes
Corporation
Not Applicable
C or S-Corp4
Yes
Yes
763
764
765
766
767
Effective January 1, 2007, the Margin Tax replaced the Texas franchise tax and is applicable to all
partnerships (other than general partnerships composed entirely of individuals). See discussion supra Part
I. General—E. Texas Entity Taxation—3. Margin Tax.
Unless a single member LLC affirmatively makes an election on IRS Form 8832 to be taxed as a
corporation, it defaults to being disregarded for federal tax purposes. Treas. Reg. § 301.7701-3(b)(ii).
Thus, where the single member of the LLC is an individual, the result is that the LLC is treated as a
proprietorship for federal income tax purposes; where the single member of the LLC is an entity, the result
is that the LLC is treated as if it were a division of the owning entity for federal income tax purposes.
Unless a partnership or multi-member LLC affirmatively makes an election on Form 8832 to be taxed as a
corporation, it defaults to being taxed as a partnership for federal tax purposes. Treas. Reg. § 301.77013(b)(i).
To be taxed as an S Corp, the entity and all its equity owners must make a timely election on Form 2553
and meet several other requirements, generally having only citizen\resident individuals or estates as equity
owners (with the exception of certain qualifying trusts and other holders), no more than 100 owners, and
only one “class of stock.” IRC § 1361(b).
Unless LP qualifies as a “passive” entity. TEX. TAX CODE § 171.0003.
Appendix B – Page 1
5030707v.1
DIRECTOR AND OFFICER FIDUCIARY DUTIES
By
BYRON F. EGAN
Jackson Walker L.L.P.
901 Main Street, Suite 6000
Dallas, TX 75202-3797
began@jw.com
LONDON • MARCH 6, 2008
Copyright© 2008 by Byron F. Egan. All rights reserved.
5030697v.1
TABLE OF CONTENTS
Page
I.
II.
III.
Introduction. ........................................................................................................................1
Fiduciary Duties Generally. ................................................................................................2
A.
General Principles....................................................................................................2
B.
Applicable Law. .......................................................................................................4
C.
Fiduciary Duties in Texas Cases..............................................................................7
1.
Loyalty. ........................................................................................................7
a.
Good Faith. ......................................................................................7
b.
Self-Dealing Transactions................................................................8
c.
Oversight..........................................................................................8
2.
Care (including business judgment rule). ....................................................8
3.
Other (obedience).......................................................................................10
D.
Fiduciary Duties in Delaware Cases. .....................................................................11
1.
Loyalty. ......................................................................................................11
a.
Conflicts of Interest........................................................................11
b.
Good Faith. ....................................................................................12
c.
Oversight/Caremark. ......................................................................13
d.
Candor............................................................................................20
2.
Care. ...........................................................................................................21
a.
Informed Action; Gross Negligence. .............................................21
b.
Inaction. .........................................................................................22
c.
DGCL § 141(e) Reliance on Reports and Records. .......................22
d.
DGCL § 102(b)(7) Limitation on Director Liability. ....................23
E.
Fiduciary Duties of Officers. .................................................................................24
F.
Derivative Actions. ................................................................................................26
G.
Effect of Sarbanes-Oxley Act of 2002 on Common Law Fiduciary Duties. .........30
1.
Overview....................................................................................................30
2.
Shareholder Causes of Action....................................................................31
3.
Director Independence. ..............................................................................31
a.
Power to Independent Directors.....................................................31
b.
Audit Committee Member Independence. .....................................36
c.
Nominating Committee Member Independence. ...........................40
d.
Compensation Committee Member Independence. .......................41
e.
State Law. ......................................................................................41
4.
Compensation. ...........................................................................................46
a.
Prohibition on Loans to Directors or Officers. ..............................46
b.
Stock Exchange Requirements. .....................................................48
c.
Fiduciary Duties.............................................................................49
5.
Related Party Transactions. .......................................................................49
a.
Stock Exchanges. ...........................................................................49
b.
Interested Director Transactions —TBOC § 21.418; TBCA Art.
2.35-1; and DGCL § 144. ..............................................................49
Shifting Duties When Company on Penumbra of Insolvency. .........................................51
i
5030697v.1
IV.
V.
VI.
A.
Insolvency Changes Relationships. .......................................................................51
B.
When is a Corporation Insolvent or in the Vicinity of Insolvency? ......................53
C.
Director Liabilities to Creditors. ............................................................................54
D.
Deepening Insolvency............................................................................................57
E.
Conflicts of Interest................................................................................................61
F.
Fraudulent Transfers. .............................................................................................62
Executive Compensation Process......................................................................................62
A.
Fiduciary Duties.....................................................................................................62
B.
Specific Cases. .......................................................................................................63
1.
Walt Disney. ..............................................................................................63
a.
Facts. ..............................................................................................63
b.
May 28, 2003 Chancery Court Opinion.........................................63
c.
September 10, 2004 Chancery Court Opinion (Ovitz’ Fiduciary
Duties Regarding His Employment Agreement). ..........................63
d.
August 9, 2005 Chancery Court Post Trial Opinion......................64
e.
June 8, 2006 Supreme Court Opinion............................................66
2.
Integrated Health........................................................................................70
3.
Sample v. Morgan......................................................................................73
4.
Ryan v. Gifford. .........................................................................................76
5.
In re Tyson Foods, Inc. Consolidated Shareholder Litigation. ..................79
6.
Desimone v. Barrows.................................................................................84
7.
Teachers’ Retirement System of Louisiana v. Aidinoff ............................86
8.
Valeant Pharmaceuticals v. Jerney ............................................................86
C.
Non-Profit Corporations. .......................................................................................88
Standards of Review in M&A Transactions......................................................................91
A.
Texas Standard of Review. ....................................................................................91
B.
Delaware Standard of Review. ..............................................................................92
1.
Business Judgment Rule. ...........................................................................93
2.
Enhanced Scrutiny. ....................................................................................94
a.
Defensive Measures. ......................................................................94
b.
Sale of Control. ..............................................................................95
3.
Entire Fairness. ..........................................................................................97
C.
Action Without Bright Lines. ................................................................................97
M&A Transaction Process. ...............................................................................................98
A.
Statutory Framework: Board and Shareholder Action..........................................98
B.
Management’s Immediate Response. ....................................................................99
C.
The Board’s Consideration. ...................................................................................99
1.
Matters Considered. ...................................................................................99
2.
Being Adequately Informed.....................................................................100
a.
Investment Banking Advice.........................................................100
b.
Value of Independent Directors, Special Committees. ................102
c.
Significant Recent Process Cases. ...............................................109
D.
Value of Thorough Deliberation..........................................................................114
E.
The Decision to Remain Independent..................................................................115
1.
Judicial Respect for Independence...........................................................116
2.
Defensive Measures. ................................................................................117
ii
5030697v.1
F.
VII.
VIII.
IX.
X.
The Pursuit of a Sale. ...........................................................................................118
1.
Value to Stockholders. .............................................................................118
2.
Ascertaining Value...................................................................................119
3.
Process Changes.......................................................................................124
4.
Disparate Treatment of Stockholders.......................................................130
5.
Protecting the Merger. .............................................................................133
a.
No-Shops......................................................................................135
b.
Lock-ups ......................................................................................136
c.
Break-Up Fees. ............................................................................137
6.
Specific Cases Where No-Shops, Lock-ups, and Break-Up Fees
Have Been Invalidated. ............................................................................138
7.
Specific Cases Where No-Shops, Lock-ups and Break-Up Fees
Have Been Upheld. ..................................................................................140
8.
Post Signing Market Check/“Go-Shop”. .................................................142
G.
Dealing with a Competing Acquiror....................................................................144
1.
Fiduciary Outs..........................................................................................144
a.
Omnicare, Inc. v. NCS Healthcare, Inc. ......................................145
b.
Orman v. Cullman........................................................................148
c.
Energy Partners, Ltd. v. Stone Energy Corp................................150
d.
Johnson & Johnson v. Guidant Corp. ..........................................151
2.
Level Playing Field. .................................................................................152
3.
Match Rights............................................................................................153
4.
Best Value................................................................................................153
H.
Postponement of Stockholder Meeting to Vote on Merger. ................................154
Responses to Hostile Takeover Attempts........................................................................155
A.
Certain Defenses. .................................................................................................155
B.
Rights Plans. ........................................................................................................156
C.
Business Combination Statutes............................................................................158
1.
DGCL § 203.............................................................................................158
2.
Texas Business Combination Statutes. ....................................................160
Going Private Transactions .............................................................................................161
A.
In re Pure Resources Shareholders Litigation......................................................161
B.
In re Emerging Communications, Inc. Shareholders Litigation ..........................164
C.
In re PNB Holding Co. Shareholders Litigation..................................................166
D.
In re SS&C Technologies, Inc. Shareholder Litigation .......................................168
E.
In re Netsmart Technologies ................................................................................169
F.
In re Topps Company Shareholders Litigation....................................................177
G.
In re Lear Corporation Shareholder Litigation ....................................................183
Director Responsibilities and Liabilities. ........................................................................185
A.
Enforceability of Contracts Violative of Fiduciary Duties ..................................185
B.
Director Consideration of Long-Term Interests. .................................................186
C.
Liability for Unlawful Distributions. ...................................................................187
D.
Reliance on Reports and Opinions.......................................................................188
E.
Inspection of Records. .........................................................................................188
F.
Right to Resign. ...................................................................................................188
Asset Transactions...........................................................................................................190
iii
5030697v.1
A.
XI.
XII.
Shareholder Approval. .........................................................................................190
1.
DGCL.......................................................................................................190
2.
Texas Corporate Statutes. ........................................................................191
3.
Model Business Corporation Act.............................................................192
B.
De Facto Merger. .................................................................................................193
Dissent and Appraisal Rights. .........................................................................................194
A.
Delaware Law. .....................................................................................................194
1.
When DGCL Appraisal Rights Are Triggered. .......................................194
2.
Who Is Entitled to DGCL Appraisal Rights. ...........................................196
3.
Procedural Aspects of DGCL Appraisal..................................................197
4.
Valuation under DGCL............................................................................198
B.
Texas Corporate Statutes. ....................................................................................199
1.
When Texas Statutory Appraisal Rights Are Triggered. .........................199
2.
Who Is Entitled to Texas Statutory Appraisal Rights..............................199
3.
Procedural Aspects of Texas Statutory Appraisal. ..................................200
4.
Valuation under Texas Corporate Statutes. .............................................202
C.
Model Business Corporation Act.........................................................................203
Conclusion.......................................................................................................................204
Appendix A – Summary of the Sarbanes-Oxley Act of 2002
Appendix B – Options Backdating Issues
Appendix C – Summary of SEC Executive Compensation Disclosure Rules
iv
5030697v.1
TABLE OF AUTHORITIES
CASES
A. Copeland Enterprises, Inc. v. Guste, 706 F. Supp. 1283
(W.D. Tex. 1989) .................................................................................5, 8, 91, 92, 156, 158
In re Abbott Laboratories Derivative Shareholders Litigation, 325 F.3d 795
(7th Cir. 2003)..............................................................................................................14, 15
Ace Ltd. v. Capital Re Corp., 747 A.2d 95 (Del. Ch. 1999) ................................135, 144, 149, 185
Angelo, Gordon & Co., L.P., et al. v. Allied Riser Communications Corporation, et al.,
2002 Del. Ch. LEXIS 11..............................................................................................54, 55
In re Appraisal of Shell Oil Co., C.A. No. 8080 (Del. Ch. Oct. 30, 1992)..................................199
In re Aquila, Inc., 805 A.2d 184 (Del. Ch. 2002) ........................................................................163
Arnold v. Society for Savings Bancorp, Inc., 650 A.2d 1270 (Del. 1994).................................4, 96
Aronson v. Lewis, 473 A.2d 805 (Del. 1984).................................................27, 43, 46, 93, 97, 105
Askanase v. Fatjo, No. H-91-3140, 1993 WL. 208440 (S.D. Tex. April 22, 1993)................51, 52
Barkan v. Amsted Indus., Inc., 567 A.2d 1279 (Del. 1989)...........97, 100, 119, 120, 121, 152, 154
Beaumont v. American Can Co., Index No. 28742/87 (N.Y. Sup. Ct. May 8, 1991)..................131
Benchmark Capital Partners IV, L.P. v. Juniper Fin. Corp., 822 A.2d 396 (Del. 2003)................6
Benchmark Capital Partners IV, L.P. v. Vague, 2002 Del. Ch. LEXIS 90 (Del. Ch. July
15, 2002), aff'd sub nom. Benchmark Capital Partners IV, L.P. v. Juniper Fin.
Corp., 822 A.2d 396 (Del. 2003) .........................................................................................6
Benson v. Braun, 155 N.Y.S.2d 622 ............................................................................................189
Berg v. Ellison, CA No. 2949-VCS (Del. Ch. June 12, 2007).............................................143, 153
Biondi v. Scrushy, C.A. No. 19896, 2003 Del. Ch. LEXIS 7 (Del. Ch. Jan. 16, 2003).................45
Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988) .................................13, 155
BNS Inc. v. Koppers Co., 683 F. Supp. 458 (D. Del. 1988).........................................................156
Boyer v. Wilmington Materials, Inc., 1997 Del. Ch. LEXIS 97 (Del. Ch. June 27, 1997)..........104
Brandin v. Deason, 2123-VCL (Del. Ch. July 20, 2007) ..............................................................77
Brazen v. Bell Atlantic Corp., 695 A.2d 43 (Del. 1997)........................................................93, 137
Bream v. Martha Stewart, 845 A.2d 1040 (Del. 2004)..................................................................46
Brehm v. Eisner, 746 A.2d 244 (Del. 2000) ..................................................................46, 103, 188
Burk Royalty Co. v. Walls, 616 S.W.2d 911 (Tex. 1981) ................................................................9
Burks v. Lasker, 441 U.S. 471 (1979)..............................................................................................3
In re Caremark International, Inc. Derivative Litigation, 698 A.2d 959 (Del. Ch. 1996).....13, 14,
15, 16, 17, 18, 19, 20, 44, 95
Cargo Partner AG v. Albatrans Inc., 352 F.3d 41 (2d Cir. 2003)...............................................193
Carl M. Loeb, Rhoades & Co. v. Hilton Hotels Corp., 222 A.2d 789, 793 (Del. 1966) .............197
Carmody v. Toll Brothers, Inc., 723 A.2d 1180 (Del. Ch. 1998) ................................................158
Carrieri v. Jobs.com, 393 F.3d 508 (5th Cir. 2004) ......................................................................51
Cates v. Sparkman, 11 S.W. 846 (1889)..........................................................................................9
Cede & Co. v. Technicolor, Inc., 634 A.2d 345 (Del. 1993) ..............11, 12, 21, 96, 109, 102, 103,
114, 118, 119
Chaffin v. GNI Group, Inc., C.A. No. 16211, 1999 Del. Ch. LEXIS 182 (Del. Ch. Sept. 3,
1999) ..................................................................................................................................46
In re CheckFree Corp., No. 3193-CC, 2007 WL 3262188 (Del. Ch. Nov. 1, 2007) ......21, 28, 172
v
4907948v.1
Cirrus Holding v. Cirrus Ind., 794 A.2d 1191 (Del Ch. 2001) ...........................................119, 136
Citron v. E.I. Du Pont de Nemours & Co., 584 A.2d 490 (Del. Ch. 1990) .........................103, 106
Citron v. Fairchild Camera & Instr. Corp., 569 A.2d 53 (Del. 1989) ............46, 99, 101, 153, 154
In re CITX Corp. Inc., 448 F.3d 672 (3d Cir. 2006)......................................................................59
Clements v. Rogers, 790 A.2d 1222 (Del. Ch. 2001)...........................................................107, 108
C.M. Asfahl Agency v. Tensor, Inc., 135 S.W.3d 768 (Tex.App.─Houston [1st Dist.]
2004) ................................................................................................................................193
In re CNET Networks Inc. Derivative Litigation, No. C-06-3817 WHA, 2007 WL
1089690 (N.D. Cal. Apr. 11, 2007) .............................................................................85, 86
Cohen v. Beneficial Industrial Loan Corp., 337 U.S. 541 (1949) ...................................................3
Continuing Creditors’ Committee of Star Telecommunications Inc. v. Edgecomb, 2004
WL 2980736 (D. Del. 2004) ..............................................................................................56
Cooper v. Pabst Brewing Co., C.A. No. 7244 (Del. Ch. June 8, 1993).......................................199
Cotton v. Weatherford Bancshares, Inc., 187 S.W.3d 687 (Tex. App.—Fort Worth 2006) .........24
Conrad v. Blank, C.A. No. 2611-VCL (Del. Ch. September 7, 2007) ..........................................77
Conway v. Bonner, 100 F.2d 786 (5th Cir. 1939)..........................................................................51
Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., C.A. No. 12150,
1991 Del. Ch. LEXIS 215 (Del. Ch. 1991)..................................................................53, 54
Crescent/Mach I Partners, L.P. v. Twiner, 846 A.2d 963 (Del. Ch. 2000) ...................................12
CRTF Corp. v. Federated Department Stores, Inc., 683 F. Supp. 422 (S.D.N.Y. 1988) ............156
Decker v. Mitchell (In re JTS Corp), 305 B.R. 529 (Bankr. N.D. Cal. 2003) ...............................52
Delta Holdings, Inc. v. National Distillers & Chemical Corp., 945 F.2d 1226 (2d Cir.
1991) [Slip opinion at 81-84].............................................................................................59
DePinto v. Landoe, 411 F.2d 297 (9th Cir. 1969) .......................................................................189
Desert Partners, L.P. v. USG Corp., 686 F. Supp. 1289 (N.D. Ill. 1988) .............99, 117, 118, 156
Desimone v. Barrows, Del. Ch. CA No. 2210-VCS June 7, 2007.................................................84
In re Digex, Inc. Shareholders Litigation, 789 A.2d 1176 (Del. Ch. 2000) ........103, 107, 108, 160
District 65 UAW v. Harper & Roe Publishers, 576 F. Supp. 1468 (S.D.N.Y 1983)...................189
Edgar v. MITE Corp., 457 U.S. 624 (1982) ................................................................................4, 5
Elliott Associates v. Avatex Corp., 715 A.2d 843 (Del. 1998) ........................................................6
Elloway v. Pate, 238 S.W.3d 882 (Tex.App.—Houston [14th Dist.] 2007)....................29, 84, 118
Emerald Partners v. Berlin, 787 A.2d 85 (Del. 2000)...................................................................24
In re Emerging Communications, Inc. Shareholders Litigation, No. CIV.A.16415, 2004
WL. 1305745 (Del. Ch. May 3, 2004).....................................................................164, 165
Emerson Radio Corp. v. International Jensen Inc., 1996 WL. 483086 (Del. Ch. 1996) ....132, 144
Energy Partners, LTD. v. Stone Energy Corp., C.A. Nos. 2374-N, 2402-N (Del. Ch. Oct.
11, 2006) ..........................................................................................................................150
Equitec-Cole Roesler v. McClanahan, 251 F. Supp. 2d 1347, 1350 (S.D. Tex. 2003) .................29
Equity-Linked Investors LP v. Adams, 705 A.2d 1040 (Del. Ch. 1997)..................................53, 54
In re Exide v. Credit Suisse First Boston, 299 B.R. 732 (Bankr. D. Del. 2003) ...........................57
Express Scripts, Inc. v. Crawford, Civil Action No. 2663-N (Del. Ch. February 13, 2007).........28
Express Scripts, Inc. v. Crawford, 2007 WL 707550 (Del. Ch. Feb. 23, 2007) ..................102, 195
In Re: F5 Networks Derivative Litigation, 2007 U.S.Dist. LEXIS 56390 (W.D. Wash.,
Aug. 1, 2007) .....................................................................................................................85
Fagan v. La Gloria Oil & Gas Co., 494 S.W.2d 624 (Tex. Civ. App.—Houston [14th
Dist.] 1973, no writ)...........................................................................................................51
vi
4907948v.1
Faour v. Faour, 789 S.W.2d 620 (Tex. App.—Texarkana 1990, writ denied) .............................24
Farnsworth v. Massey, 365 S.W.2d 1 (Tex. 1963)......................................................................200
FDIC v. Benson, 867 F. Supp. 512 (S.D. Tex. 1994) ......................................................................9
FDIC v. Brown, 812 F. Supp. 722 (S.D. Tex. 1992) .......................................................................9
FDIC v. Harrington, 844 F. Supp. 300 (N.D. Tex. 1994) ...........................................................7, 9
FDIC v. Schreiner, 892 F. Supp. 869 (W.D. Tex. 1995).................................................................9
FDIC v. Wheat, 970 F.2d 124 (5th Cir. 1992) .............................................................................189
Fed. United Corp. v. Havender, 11 A.2d 331, 342 (Del. 1940) ..................................................195
Field v. Allyn, 457 A.2d 1089 (Del. Ch.), aff’d 467 A.2d 1274 (Del. 1983) ...............................195
In re First Boston, Inc. Shareholders Litigation, 1990 Del. Ch. LEXIS 74, Fed. Sec. L.
Rep. (CCH) 95322 (Del. Ch. June 7, 1990).....................................................................108
First Marblehead Corp. v. House, 473 F.3d 1, 6 (1st Cir. 2006) ..................................................78
Flanary v. Mills, 150 S.W.3d 785 (Tex. App. - Austin 2004).........................................................7
Fliegler v. Lawrence, 361 A.2d 218 (Del. 1976)...........................................................................50
Floyd v. Hefner, 2006 WL 2844245 (S.D. Tex. Sept. 29, 2006) .....................................3, 9, 51, 52
In re FLS Holdings, Inc. S'holders Litigation, 1993 WL 104562 (Del. Ch. Apr. 21, 1993) .......109
Fogel v. U.S. Energy Systems Inc., No. 3271-CC (Del. Ch. Dec. 13, 2007) ...................................3
In re Fort Howard Corp. Shareholders Litig., 1988 WL 83147 (Del. Ch. 1988) ..............105, 106,
119, 143
Frantz Manufacturing Co. et al. v. EAC Industries, 501 A.2d 401 (Del. 1985)..........................188
Friese v. Superior Court of San Diego County, 36 Cal. Rptr. 3d 558 (Cal. Ct. App. 2005) ...........6
Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970), cert denied, 401 U.S. 974 (1971).........78
Gearhart Industries, Inc. v. Smith International, Inc., 741 F.2d 707 (5th Cir. 1984) ............3, 4, 5,
7, 8, 9, 10, 30, 41, 42, 51, 91, 92, 156
In re General Homes Corp., 199 B.R. 148 (S.D. Tex. 1996) ........................................................52
Gerdes v. Reynolds, 28 N.Y.S.2d 622 (N.Y. S.Ct. 1941) ............................................................189
Gesoff v. IIC Indus. Inc., C.A. Nos. 19473, 19600 (Del. Ch. May 18, 2006)..............................112
Geyer v. Ingersoll Pub. Co., 621 A.2d 784 (Del.Ch. 1992) ........................................52, 53, 54, 57
Gimbel v. The Signal Companies, Inc., 316 A.2d 599 (Del. Ch. 1974).......................................190
Globis Partners, L.P. v. Plumtree Software, Inc., 1577-VCP (Del. Ch. Nov. 30, 2007) .....95, 173
Golden Cycle, LLC v. Allan, 1998 WL 892631 (Del. Ch. December 10, 1998) ...........................99
Goodwin v. Live Entertainment, Inc., 1999 WL 64265 (Del. Ch. 1999)......................45, 100, 101,
138, 140, 154
Grand Metropolitan Public, Ltd. v. Pillsbury Co., 558 A.2d 1049 (Del. Ch. 1988) ...........156, 157
Grimes v. Donald, 673 A.2d 1207 (Del. 1996)............................................................................105
Grobow v. Perot, 539 A.2d 180 (Del. 1988) ...............................................................................105
Guth v. Loft, 5 A.2d 503 (Del. 1939) .......................................................................................11, 12
Harbor Finance Partners v. Huizenga, 751 A.2d 879 (Del. Ch. 1999) ........................................46
Hariton v. Arco Elecs., Inc., 182 A.2d 22, 25 (Del. Ch. 1962)............................................194, 195
Heineman v. Datapoint Corp., 611 A.2d 950 (Del. 1992).............................................................46
Hixson v. Pride of Texas Distributing Co., 683 S.W.2d 173 (Tex.App.-Fort Worth 1985,
no writ)...............................................................................................................................51
Hochberg v. Schick Investment Company, 469 S.W.2d 474, 476 (Civ. App.—Fort Worth
1971, no writ)...................................................................................................................200
Hollaway v. Skinner, 898 S.W.2d 793 (Tex. 1995) .......................................................................25
vii
4907948v.1
Hollinger Inc. v. Hollinger International, Inc., 858 A.2d 342 (Del. Ch. 2004), appeal
refused, 871 A.2d 1128 (Del. 2004) ................................................................190, 191, 196
Hollis v. Hill, 232 F.3d 460 (5th Cir. 2000).....................................................................................5
In re Holly Farms Corp. Shareholders Litigation, 564 A.2d 342 (Del. Ch. 1988) .............140, 156
Indiana Electrical Workers Pension Fund v. Millard, S.D.N.Y., No. 07 Civ. 172 (JGK),
7/24/07) ..............................................................................................................................86
In Re: INFOUSA, Inc. Shareholders Litigation, CA No. 1956-CC (Del. Ch. August 20,
2007) ..............................................................................................................21, 44, 45, 169
International Bankers Life Insurance Co. v. Holloway, 368 S.W.2d 567 (Tex. 1967) ...................7
International Telecharge, Inc. v. Bomarko, Inc., 766 A.2d 437 (Del. 2000) ..............................107
Invacare Corporation v. Healthdyne Technologies, Inc., 968 F. Supp. 1578 (N.D. Ga.
1997) ................................................................................................................................158
Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334 (Del. 1987)..................................118
In re IXC Communications, Inc. Shareholders Litigation, 1999 WL 1009174 (Del. Ch.
1999) ................................................................................................................101, 135, 149
Jackson v. Turnbull, C.A. No. 13042 (Del. Ch. Feb. 8, 1994) ............................................132, 197
Jedwab v. MGM Grand Hotels, Inc., 509 A.2d 584 (Del. Ch. 1986) ..................................104, 131
Johnson & Johnson v. Guidant Corp., 06 Civ. 7685 (S.D.N.Y. Aug. 29, 2007) ........................151
Joseph Greenspon's Sons Iron & Steel Co. v. Pecos Valley Gas Co., 156 A. 350 (Del. Ch.
193l) ...................................................................................................................................25
Kahn v. Dairy Mart Convenience Stores, Inc., 1996 Del. Ch. LEXIS 38 (Del. Ch. March
29, 1996) ..........................................................................................................104, 106, 108
Kahn v. Lynch Communications Systems, Inc., 638 A.2d 1110 (Del. 1994) ..................61, 97, 108,
162, 166, 167, 168
Kahn v. Lynch Communications Systems, Inc., 669 A.2d 79 (Del. 1995) ...................................107
Kahn v. MSB Bancorp, Inc., 1998 WL 409355 (Del. Ch. 1998), aff'd 734 A.2d 158 (Del.
1999) ................................................................................................................102, 115, 117
Kahn v. Roberts, 679 A.2d 460 (Del. 1996) ................................................................................104
Kahn v. Sullivan, 594 A.2d 48 (Del. 1991)..........................................................................104, 107
Kahn v. Tremont Corp., 694 A.2d 422 (Del. 1997) .......................................46, 103, 105, 106, 108
Katell v. Morgan Stanley Group, Inc., 1995 Del. Ch. LEXIS 76, Fed. Sec. L. Rep. (CCH)
98861 (Del. Ch. June 15, 1995) .......................................................................................105
In re KDI Corp. Shareholders Litigation, 1990 Del. Ch. LEXIS 201, Fed. Sec. L. Rep.
(CCH) 95727 (Del. Ch. Dec. 13, 1990) ...........................................................................106
Knapp v. North American Rockwell Corp., 506 F.2d 361 (3rd Cir. 1974), cert. den. 421
U.S. 965 (1975)................................................................................................................193
Kohls v. Duthie, 765 A.2d 1274 (Del. Ch. 2000).........................................................103, 104, 107
Krim v. ProNet, Inc., 744 A.2d 523 (Del. 1999)..........................................................................119
Landon v. S&A Marketing Group, Inc., 82 S.W.2d 3rd 666 (Tx. App. Eastland 2002)........7, 8, 50
In re Lear Corporation Shareholder Litigation, 2007 WL 173258 (Del. Ch. June 15,
2007) ................................................................................................................143, 183, 184
Leonard Loventhal Account v. Hilton Hotels Corp., C.A. No. 17803, 2000 WL. 1528909
(Del. Ch. Oct. 10, 2000)...................................................................................................156
Levco Alternative Fund Ltd. v. Reader's Digest Association, Inc., 803 A.2d 428 (Del.
Aug. 13, 2002) .........................................................................................................109, 111
Lewis v. Anderson, 477 A.2d 1040, 1047–49 (Del. 1984).............................................................29
viii
4907948v.1
Lewis v. Fuqua, 502 A.2d 962 (Del. Ch. 1985) .............................................................................46
Lifshutz v. Lifshutz, 199 S.W.3d 9 (Tex. App.-San Antonio 2006) ...............................................24
In re Linear Technology Corp. Derivative Litigation, 2006 WL 3533024 (N.D.Cal. Dec.
7, 2006) ..............................................................................................................................85
In re LNR Property Corp. Shareholder Litigation (Del. Ch., Consolidated C.A. No.
674-N, November 4, 2005) ..............................................................................................110
Louisiana Municipal Police Employees’ Retirement Sys. v. Crawford, Civil Action No.
2635-N (Del. Ch. February 13, 2007)................................................................................28
Louisiana Municipal Police Employees’ Retirement System v. Crawford, 2007 WL
582510 (Del. Ch. Feb. 23, 2007) .............................................................................102, 195
In re Lukens Inc. Shareholders Litig., 757 A.2d at 738...............................................................154
MAI Basic Four, Inc. v. Prime Computer, Inc., [1988-89 Transfer Binder], Fed. Sec. L.
Rep. (CCH) ¶ 94,179 (Del. Ch. 1988) .............................................................................156
Malone v. Brincat, 722 A.2d 5 (Del 1998) ................................................................................4, 51
Marron v. Ream, Civil Action No. H-06-1394, 2006 U.S. Dist. LEXIS 72831 (S.D. Tex.
May 8, 2006)................................................................................................................29, 30
Massey v. Farnsworth, 353 S.W.2d 262, 267-268 (Civ. App.—Houston 1961), rev’d on
other grounds, 365 S.W.2d 1 (Tex. 1963) .......................................................................199
Matador Capital Management Corp. v. BRC Holdings, Inc., 729 A.2d 280 (Del. Ch.
1998) ..................................................................................99, 118, 135, 137, 138, 140, 154
Matulich v. Aegis Communications Group, Inc., ____ A.2d ____ (Del. Jan. 15, 2008) .................5
In re MAXXAM, Inc./Federated Development Shareholders Litigation, 659 A.2d 760
(Del. Ch. 1995) ..........................................................................................................46, 105
In re MAXXAM, Inc./Federated Development Shareholders Litigation, 1997 Del. Ch.
LEXIS 51 (Del. Ch. Apr. 4, 1997)...........................................................................103, 106
McCollum v. Dollar, 213 S.W. 259 (Tex. Comm'n App. 1919, holding approved)................7, 8, 9
McDermott, Inc. v. Lewis, 531 A.2d 206 (Del. 1987)......................................................................4
McMillan v. Intercago Corp., 768 A.2d 492 (Del. Ch. 2000) .....................................................119
Mendel v. Carroll, 651 A.2d 297 (Del. Ch. 1994).......................................................................137
Mercier v. Inter-Tel, (Delaware) Incorporated, 2007 WL 2332454 (Del. Ch. 2007).................154
M.G. Bancorporation Inc. v. LeBeau, 737 A.2d 513, 526 (Del. 1999) .......................................199
Michelson v. Duncan, 407 A.2d 211 (Del. 1979) ..........................................................................50
Milam v. Cooper Co., 258 S.W.2d 953 (Tex. Civ. App.—Waco 1953, writ ref'd n.r.e.) ................8
Mills Acquisition Co. v. Macmillan, Inc., 559 A.2d 1261 (Del. 1988).........97, 100, 101, 102, 105,
106, 109, 116, 119, 137, 138, 144, 152, 153
Mills Acquisition Co. v. Macmillan, Inc., 1988 WL 108332 [1988-89 Transfer Binder],
Fed. Sec. L. Rep. (CCH) ¶ 94,071 (Del. Ch. 1988), rev'd on other grounds, 559
A.2d 1261 (Del. 1989) .....................................................................................................156
Missouri Pacific Railway v. Shuford, 72 Tex. 165, 10 S.W. 408 (1888) ........................................9
Mizel v. Connelly, C.A. No. 16638, 1999 Del. Ch. LEXIS 157 (Del. Ch. July 22, 1999) ............46
In re MONY Group Inc. Shareholder Litigation, 852 A.2d 9 (Del. Ch. 2004)........................4, 121
In re MONY Group Inc. Shareholders Litigation, 853 A.2d 661 (Del. Ch. 2004) ......................124
Moore Business Forms, Inc. v. Cordant Holdings Corp., 1996 Del. Ch. LEXIS 56 (Del.
Ch. June 4, 1996) .............................................................................................................104
Moore Corp. Ltd. v. Wallace Computer Services, Inc., 907 F. Supp. 1545 (D. Del. 1995) .......114,
115, 118, 156
ix
4907948v.1
Moran v. Household International, Inc., 490 A.2d 1059 (Del. Ch.), aff'd, 500 A.2d 1346
(Del. 1985) .........................................................................................................................21
Moran v. Household International, Inc., 500 A.2d 1346 ............................................114, 118, 156
In re Netsmart Technologies, 924 A.2d 171 (Del. Ch. 2007)......................143, 169, 172, 175, 184
North American Catholic Educational Programming Foundation Inc. v. Gheewalla,
930 A2d 92, 2007 WL 1453705 (Del. 2007) ...................................................51, 52, 54, 60
Odyssey Partners v. Fleming Companies, 735 A.2d 386 (Del. Ch. 1999) ..............................43, 53
Official Committee of Unsecured Creditors of Integrated Health Services, Inc. v. Elkins,
2004 WL 1949290 (Del. Ch. Aug. 24, 2004) ........................................................22, 70, 72
Official Committee of Unsecured Creditors v. R.F. Lafferty Co., Inc., 267 F.3d 340 (3d
Cir. 2001) ...........................................................................................................................57
Oliver v. Boston University, C.A. No. 16570 (Del. Ch. Apr. 14, 2006) ......................................113
Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914 (Del. 2003)..........................145, 146, 147,
148, 149
Onti, Inc. v. Integra Bank, 751 A.2d 904, 907 (Del. Ch. 1999)...................................................199
In Re Oracle Corp. Derivative Litigation, 824 A.2d 917, 2003 WL. 21396449 (Del. Ch.
2003) ......................................................................................................................26, 44, 46
Orman v. Cullman, 794 A.2d 5 (Del. Ch. 2002)............................................................................45
Orman v. Cullman (General Cigar), C.A. No. 18039, 2004 Del. Ch. LEXIS 150 (Del.
Ch. Oct. 20, 2004)....................................................................................................148, 149
Pace v. Jordan, 999 S.W.2d 615, 622 (Tex. App. – Houston [1st Dist.] 1999, pet. denied).........26
Paramount Communications Inc. v. QVC Network Inc., 637 A.2d 34 (Del. 1994)..........94, 95, 96,
100, 102, 115, 118, 119, 122, 127, 128, 134, 135, 136, 138, 139, 144, 146, 152,
153, 185
Paramount Communications, Inc. v. Time, Inc., 571 A.2d 1140 (Del. 1989) ..............96, 103, 114,
115, 116, 11\8, 119
Paramount Communications Inc. v. Time Inc., 1988 WL 79880 (Del. Ch. 1988) [1989
Transfer Binder], Fed. Sec. L. Rep. (CCH) ¶ 94,514 (Del. Ch. 1988), aff'd, 571
A.2d 1140 (Del. 1989) .....................................................................................................157
Parfi Holding AB v. Mirror Image Internet, Inc., 794 A.2d 1211 (Del. Ch. 2001), rev'd in
part on other grounds, 817 A.2d 149 (Del. 2002), cert. denied, 123 S. Ct. 2076
(2003).................................................................................................................................43
Parkview Gen. Hosp. v. Waco Constr., Inc., 531 S.W.2d 224, 228 (Civ. App.—Corpus
Christi 1975, no writ).......................................................................................................201
Parnes v. Bally Entm’t Corp., 722 A.2d 1243 (Del. 1999)............................................................29
Pate v. Elloway, No. 01-03-00187-CV, 2003 WL 22682422 (Tex.App.—Houston [1st
Dist.] Nov. 13, 2003, pet. denied)......................................................................................29
In re Pennaco Energy, Inc. Shareholders Litigation, 787 A.2d 691 (Del. Ch. 2001) .................138
People ex rel Spitzer v. Grasso, 2007 NY Slip Op 03990 (Supreme Court, Appellate
Division, May 8, 2007) ......................................................................................................90
Pepper v. Litton, 308 U.S. 295 (1939).....................................................................................91, 92
Pereira v. Cogan, 294 B.R. 449 (SDNY 2003), reversed on other grounds and
remanded, Pereira v. Farace, 413 F.3d 330 (2nd Cir. 2005) ................................24, 55, 56
Pereira v. Farace, 413 F.3d 330 (2nd Cir. 2005) ....................................................................24, 56
In re Performance Nutrition, Inc., 237 B.R. 93 (Bankr. N.D. Tex. 1999) ....................................52
x
4907948v.1
Phelps Dodge Corp. v. Cypress Amax Minerals Co., 1999 WL 1054255 (Del. Ch. 1999)........129,
135, 144
Philadelphia Electric Co. v. Hercules, Inc., 762 F.2d 303 (3rd Cir. 1985).................................193
Plas-Tex v. Jones, 2000 WL. 632677 (Tex. App.-Austin 2002; not published in S.W.3d) ..........52
In re Ply Gem Industrial, Inc. S'holders Litigation, C.A. No. 15779-NC, 2001 Del. Ch.
LEXIS 84 (Del. Ch. 2001) .................................................................................................45
In re PNB Holding Co. Shareholders Litigation, 2006 WL 2403999 (Del. Ch. Aug. 18,
2006) ........................................................................................................................166, 167
Pogostin v. Rice, 480 A.2d 619 (Del. 1984) ........................................................................105, 116
Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772 (Del. Ch. 2004).....54, 56
In re Pure Resources Shareholders Litigation, 808 A.2d 421 (Del. Ch. 2002)...................161, 172
Quark Inc. v. Harley, 1998 U.S. App. LEXIS 3864 (10th Cir. March 4, 1998)..........................189
Quickturn Design System, Inc. v. Shapiro, 721 A.2d 1281 (Del. 1998) ................94, 117, 157, 158
Raab v. Villager Indus., Inc., 355 A.2d 888, 894 (Del. 1976), cert. denied sub nom.
Mitchell v. Villager Indus., Inc., 429 U.S. 853 (1976).....................................................197
Rabkin v. Olin Corp., 1990 Del. Ch. LEXIS 50, Fed. Sec. L. Rep. (CCH) 95255 (Del.
Ch. Apr. 17, 1990), reprinted in 16 Del. J. Corp. L. 851 (1991), aff'd, 586 A.2d
1202 (Del. 1990) ..............................................................................................................107
Rales v. Blasband, 634 A.2d 927, 936 (Del. 1993) .............................................................105, 106
Rand, 1994 WL 89006.........................................................................................................137, 141
Raynor v. LTV Aerospace Corp., 317 A.2d 43, 46 (Del. Ch. 1974) ............................................198
In re Reading Co., 711 F.2d 509 (3d Cir. 1983)..........................................................................132
In re Resorts International Shareholders Litigation, 570 A.2d 259 (Del. 1990) ................103, 108
Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1985)..............95, 115,
117, 118, 119, 121, 122, 124, 126, 127, 129, 135, 137, 138, 139, 141, 143, 148,
152, 153, 173, 178, 179, 182, 183, 184
Roberts v. General Instrument Corp., 1990 WL 118356 (Del. Ch. 1990) ..........134, 137, 141, 142
Romero v. US Unwired, Inc., No. 04-2312, 2006 WL 2366342 (E.D. La. Aug. 11, 2006) ..........29
RTC v. Acton, 844 F. Supp., 307 (N.D. Tex. 1994) .........................................................................9
RTC v. Miramon, 22 F.3d 1357 (5th Cir. 1994) ..............................................................................9
RTC v. Norris, 830 F. Supp. 351 (S.D. Tex. 1993)....................................................................9, 10
Rudisill v. Arnold White & Durkee, P.C., 148 S.W.3d 556 (Tex. App. 2004) ............................192
Ryan v. Gifford, 918 A.2d 341 (Del. Ch. Feb. 6, 2007)...............................................27, 76, 84, 85
Ryan v. Gifford, 2007 WL 4259557 (Del. Ch. Dec. 3, 2007) ........................................................78
Saito v. McCall, C.A. No. 17132-NC, 2004 WL 3029876 (Del. Ch. Dec 20, 2004) ....................16
Sample v. Morgan, 914 A.2d 647 (Del. Ch. Jan. 23, 2007)...........................................................73
Sample v. Morgan, 2007 WL 4207790 (Del. Ch. Nov. 27, 2007).................................................75
Schacht v. Brown, 711 F.2d 1343 (7th Cir 1983) ..........................................................................57
Schilling v. Belcher, 582 F.2d 995 (5th Cir. 1978) ........................................................................29
Schrage v. Bridgeport Oil Co., Inc., 71 A.2d 882 (Del. Ch. 1950) .............................................131
In re Scott Acq. Corp., 344 B.R. 283 (Bankr. D. Del.) ..................................................................57
Seagraves v. Urstady Property Co., 1996 Del. Ch. LEXIS 36 (Del. Ch. Apr. 1, 1996) .............104
Sealy Mattress Co. of New Jersey, Inc. v. Sealy, Inc., No. 8853, 1987 WL 12500 (Del.
Ch. June 19, 1987) .............................................................................................................78
Selfe v. Joseph, 501 A.2d 409, 411 (Del. 1985)...........................................................................199
Sheppard v. A.C.&S Co., Inc., 484 A.2d 521 (Del. Super. 1984)................................................194
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In re Siliconix, 2001 WL 716787 (Del. Ch. June 21, 2001) ........................................................163
Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971)) ......................................................93
Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985).......................................21, 22, 93, 99, 100, 101,
103, 114, 116, 121, 144
SmithKline Beecham Corp. v. Rohm and Haas Corp., 89 F.3d 154 (3rd Cir. 1996)...................193
Solash v. Telex Corp., 1988 WL 3587 (Del. Ch. Jan. 19, 1988)....................................................11
Solomon v. Pathe Communications Corp, 672 A.2d 35 (Del. 1996)...................................162, 163
Spiegal v. Buntrock, 571 A.2d 767 (Del. 1990)...........................................................................104
In re SS&C Technologies, Inc. Shareholder Litigation, 911 A.2d 816 (Del. Ch. 2006) .....104, 168
Stanziale v. Pepper Hamilton, LLP, (In re Student Finance Corp.), 355 B.R. 539 (D. Del.
2005) ..................................................................................................................................57
State v. Nevitt, 595 S.W.2d 140 (Tex.App.-Dallas 1980, writ ref'd n.r.e.) ....................................51
Stephenson v. Commonwealth & S. Corp., 156 A.215, 216 (Del. Ch. 1931), aff’d on other
grounds, 168 A. 211 (Del. 1933) .....................................................................................197
Stone v. Ritter, 911 A.2d 362, 2006 WL 3169168 (Del. 2006) .........................4, 12, 13, 17, 19, 22
Story v. Kennecott Copper Corporation, 394 N.Y.S. 2d 353, Sup. Ct. (1977) ...........................190
Strassburger v. Earley, 752 A.2d 557 (Del. Ch. 2000) .................................12, 106, 107, 108, 109
Sullivan Money Management, Inc. v. FLS Holdings, Inc., Del. Ch., C.A. No. 12731 (Nov.
20, 1992), aff'd, 628 A.2d 84 (Del. 1993)............................................................................5
T. Rowe Price Recovery Fund, L.P. v. Rubin, 770 A.2d 536 (Del. Ch. 2000) ............................103
T.A. Pelsue Co. v. Grand Enterprises Inc., 782 F. Supp. 1476 (D. Colo. 1991) .........................189
In re Talley Indus., Inc. Shareholders Litigation, 1998 WL. 191939 (Del. Ch. 1998) ...............100
Teachers’ Retirement System of Louisiana v. Aidinoff, 900 A.2d 654 (Del. Ch. 2006) ................86
In re Tele-Communications, Inc. Shareholders Litig., C.A. No. 16470, Chandler, C. (Del.
Ch. Dec. 21, 2005, revised January 10, 2006) .................................................................109
In re Telesport Inc., 22 B.R. 527 (Bankr. E.D. Ark. 1982) .........................................................188
In re The Limited, Inc. S'holders Litigation, 2002 Del. Ch. LEXIS 28, 2002 WL 537692
(Del. Ch. Mar. 27, 2002)....................................................................................................46
Thorpe v. CERBCO, Inc., 676 A.2d 436 (Del. 1996) ..................................................................190
Tooley v. Donaldson, Lufkin & Jenrette, 845 A.2d 1031 (Del. 2004)...........................................29
In re Topps Company Shareholder Litigation, CA No. 2998-VCS June 19, 2007 .....143, 153, 177
In re Toys “R” Us, Inc. Shareholder Litigation, 877 A.2d 975 (Del. Ch. 2005) ........................124
In re Trans World Airlines, Inc. Shareholders Litig., 1988 Del. Ch. LEXIS 139 (Del. Ch.
Oct. 21, 1988) reprinted in 14 Del. J. Corp. L. 870 (1989) .............................................109
Trenwick America Litigation Trust v. Ernst & Young LLP, et al., 906 A.2d 168 (Del. Ch.
2006) ......................................................................................................................57, 58, 59
TW Services v. SWT Acquisition Corp., C.A. No. 10427, 1989 Del. Ch. LEXIS 19 (Mar.
2, 1989) ............................................................................................................................157
In re Tyson Foods, Inc. Consolidated Shareholder Litigation, 919 A.2d 563, 2007 WL
416132 (Del.Ch. Feb. 6, 2007) ........................................................................26, 79, 84, 85
In re Tyson Foods, Inc. Consolidated Shareholder Litigation, C.A. No. 1106-CC
(Del.Ch. August 15, 2007).................................................................................................84
In re United Finance Corporation, 104 F.2d 593 (7th Cir. 1939).................................................54
Unitrin, Inc. v. America General Corp., 651 A.2d 1361 (Del. 1995)....95, 100, 102, 116, 117, 118
Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985) ...........93, 94, 99, 100, 102, 115,
117, 127, 133, 138, 146, 147, 148, 153, 155
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Valeant Pharmaceuticals International v. Jerney, 2007 WL 704935 (Del. Ch. March 1,
2007) ......................................................................................................................86, 87, 88
VantagePoint Venture Partners v. Examen, Inc., 871 A.2d 1108 (Del. 2005)................................5
In re Vitalink Communications Corp. Shareholders Litigation, 1991 WL 238816 (Del.
Ch. 1991)..........................................................................................................101, 120, 141
In re Walt Disney Co. Derivative Litigation, 731 A.2d 342 (Del. Ch. 1998), aff'd in part,
rev'd in part sub nom. Brehm v. Eisner, 746 A.2d 244 (Del. 2000) ..................................46
In re The Walt Disney Co. Derivative Litigation, 825 A.2d 275 (Del. Ch. 2003).............63, 71, 72
In re The Walt Disney Co. Derivative Litigation, 907 A.2d 693 (Del. Ch. 2005)...................63, 64
In re The Walt Disney Co. Derivative Litigation, 906 A.2d 27 (Del. 2006)...............12, 17, 18, 25,
63, 66
Warner Communications Inc. v. Chris-Craft Indus., Inc., 583 A.2d 962 (Del. Ch. 1989)..........5, 6
Watchmark Corp. v. Argo Global Capital, LLC, et al, C.A. 711-N (Del. Ch. November 4,
2004) ....................................................................................................................................6
Weaver v. Kellog, 216 B.R. 563 (S.D. Tex. 1997).........................................................................61
Weinberger v. UOP, Inc., 457 A.2d 701 (Del. 1983) ..............................................87, 97, 101, 108
Weinstein Enterprises, Inc. v. Orloff, 870 A.2d 499 (Del. 2005) ................................................191
In re Western National Corp. Shareholders Litigation, 2000 WL 710192 (Del. Ch. May
22, 2000) ..........................................................................................................................103
Williams v. Geier, 671 A.2d 1368 (Del. 1996) ..............................................................................93
Wingate v. Hajdik, 795 S.W.2d 717, 719 (Tex. 1990)...................................................................26
Xerox Corp. v. Genmoora Corp., 888 F.2d 345 (5th Cir.1989)...................................................189
Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981) ...............................................................24
Zauber v. Murray Sav. Ass’n, 591 S.W.2d 932, 937-938 (Tex. Civ. App. 1979) .........................29
Zirn v. VLI Corp., 621 A.2d 773 (Del. 1993) ................................................................................24
In re Zoran Corporation Derivative Litigation, 2007 WL 1650948 (N.D. Cal. June 5,
2007) ............................................................................................................................85, 86
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DIRECTOR AND OFFICER
FIDUCIARY DUTIES
By
Byron F. Egan, Dallas, TX∗
I.
Introduction.
The conduct of directors and officers is subject to particular scrutiny in the context of
executive compensation and other affiliated party transactions, business combinations, whether
friendly or hostile, and when the corporation is charged with illegal conduct. The high profile
stories of how much corporations are paying their chief executive officer (“CEO”) and other
executives, corporate scandals, bankruptcies and related developments have further focused
attention on how directors and officers discharge their duties, and have caused much
reexamination of how corporations are governed and how they relate to their shareholders.
The individuals who serve in leadership roles for corporations are fiduciaries in relation
to the corporation and its owners. These times make it appropriate to focus upon the fiduciary
and other duties of directors and officers, including their duties of care, loyalty and oversight.
Increasingly the courts are applying principals articulated in cases involving mergers and
acquisitions (“M&A”) to cases involving executive compensation, perhaps because both areas
often involve conflicts of interest and self-dealing or because in Delaware, where many of the
cases are tried, the same judges are writing significant opinions in both areas. Director and
officer fiduciary duties are generally owed to the corporation and its shareholders, but when the
corporation is on the penumbra of insolvency, the beneficiaries of those duties may begin to
expand to include the creditors.
Congressional focus on how corporations should be governed following corporate
debacles earlier in this decade led to the Sarbanes-Oxley Act of 2002 (“SOX”),1 which President
∗
1
Copyright © 2007 by Byron F. Egan. All rights reserved.
Byron F. Egan is a partner of Jackson Walker L.L.P. in Dallas, Texas. Mr. Egan is a Vice-Chair of the ABA Business
Law Section’s Negotiated Acquisitions Committee and former Co-Chair of its Asset Acquisition Agreement Task
Force, which published the ABA Model Asset Purchase Agreement with Commentary (2001). He is also a member of
the American Law Institute. Mr. Egan is a former Chairman of the Texas Business Law Foundation and is also former
Chairman of the Business Law Section of the State Bar of Texas and of that Section’s Corporation Law Committee.
The author wishes to acknowledge the contributions of the following in preparing this paper: Michael L. Kaufman,
Michael L. Laussade and Monica L. Pace of Jackson Walker, L.L.P. in Dallas, Texas and Mark A. Morton of Potter
Anderson & Corroon LLP in Wilmington, Delaware.
Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (codified in several sections of 15 U.S.C.A.)
(“SOX”); see Byron F. Egan, The Sarbanes-Oxley Act and Its Expanding Reach, 40 Texas Journal of Business Law
305 (Winter 2005), which can be found at http://www.jw.com/site/jsp/publicationinfo.jsp?id=505; Byron F. Egan,
Communicating with Auditors After the Sarbanes-Oxley Act, 41 Texas Journal of Business Law 131 (Fall 2005); and
Byron F. Egan, Communications with Accountants After the Sarbanes-Oxley Act (including Attorney Letters to
Auditors re Loss Contingencies, Attorney Duties under SOX §§ 303 and 307, Options Backdating) (Oct. 24, 2006),
which can be found at http://www.jw.com/site/jsp/publicationinfo.jsp?id=624.
1
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Bush signed on July 30, 2002. SOX was intended to protect investors by improving the accuracy
and reliability of corporate disclosures made pursuant to the securities laws.2
While SOX and related changes to SEC rules and stock exchange listing requirements
have mandated changes in corporate governance practices, our focus will be on state corporate
statutes and common law.3 Our focus will be in the context of companies organized under the
Delaware General Corporation Law (as amended to date, the “DGCL”) and the applicable Texas
statutes.
Prior to January 1, 2006, Texas business corporations were organized under, and many
are still governed by, the Texas Business Corporation Act, as amended (the “TBCA”),4 which
was supplemented by the Texas Miscellaneous Corporation Laws Act (the “TMCLA”).5
However, corporations formed after January 1, 2006 are organized under and governed by the
Texas Business Organization Code (“TBOC”).6 For entities formed before that date, only the
ones voluntarily opting into the TBOC will be governed by the TBOC until January 1, 2010, at
which time all Texas corporations will be governed by the TBOC. However, because until 2010
some Texas for-profit corporations will be governed by the TBCA and others by the TBOC and
because the substantive principles under both statutes are generally the same, the term “Texas
Corporate Statutes” is used herein to refer to the TBOC and the TBCA (as supplemented by the
TMCLA) collectively, and the particular differences between the TBCA and the TBOC are
referenced as appropriate.7
II.
Fiduciary Duties Generally.
A.
General Principles.
The concepts that underlie the fiduciary duties of corporate directors have their origins in
English common law of both trusts and agency from over two hundred years ago. The current
2
3
4
5
6
7
The SOX is generally applicable to all companies required to file reports, or that have a registration statement on file,
with the Securities and Exchange Commission (“SEC”) regardless of size (“public companies”). Although the SOX
does have some specific provisions, and generally establishes some important public policy changes, it is implemented
in large part through rules adopted by the SEC. See Summary of the Sarbanes-Oxley Act of 2002 attached as
Appendix A. Among other things, the SOX amends the Securities Exchange Act of 1934 (the “1934 Act”) and the
Securities Act of 1933 (the “1933 Act”).
See William B. Chandler III and Leo E. Strine Jr., The New Federalism of the American Corporate Governance
System: Preliminary Reflections of Two Residents of One Small State (February 26, 2002), which can be found at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=367720; cf. Myron T. Steele, Judicial Scrutiny of Fiduciary Duties
in Delaware Limited Partnerships and Limited Liability Companies, 32 DEL. J. CORP. L. 1 (2007); Leo E. Strine, Jr.,
Toward A True Corporate Republic: A Traditionalist Response to Bebchuk’s Solution for Improving Corporate
America, 119 Harvard L. Rev. 1759 (2006).
TEX. BUS. CORP. ANN. arts. 1.01 et. seq. (Vernon Supp. 2007).
TEX. REV. CIV. STAT. ANN. art. 1302 (Vernon Supp. 2007).
The TBOC provides that the TBOC provisions applicable to corporations (TBOC Titles 1 and 2) may be officially and
collectively known as “Texas Corporation Law” (TBOC § 1.008(b)). See Byron F. Egan, Choice of Entity Decision
Tree (May 18, 2007), which can be found at http://www.jw.com/site/jsp/publicationinfo.jsp?id=796.
The term “charter” is used herein interchangeably with (i) “certificate of incorporation” for Delaware corporations,
(ii) “certificate of formation” for corporations governed by the TBOC and (iii) “certificate of incorporation” for
corporations organized under the TBCA, in each case as the document to be filed with the applicable Secretary of State
to form a corporation.
2
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concepts of those duties in both Texas and Delaware are still largely matters of evolving
common law.8
Both the Texas Corporate Statutes and the DGCL provide that the business and affairs of
a corporation are to be managed under the direction of its board of directors (“Board”).9 While
the Texas Corporate Statutes and the DGCL provide statutory guidance as to matters such as the
issuance of securities, the payment of dividends, the notice and voting procedures for meetings
of directors and shareholders, and the ability of directors to rely on specified persons and
information, the nature of a director’s “fiduciary” duty to the corporation and the shareholders
has been largely defined by the courts through damage and injunctive actions.10 In Texas, the
8
9
10
The “fiduciary duties of corporate officers and directors ... are creatures of state common law[.]” Gearhart Industries,
Inc. v. Smith Intern., Inc., 741 F.2d 707, 719 (5th Cir. 1984) (citing Cohen v. Beneficial Industrial Loan Corp., 337
U.S. 541, 549 (1949)); see also Burks v. Lasker, 441 U.S. 471, 477 (1979). Federal courts generally apply applicable
state common law in fiduciary duty cases. Floyd v. Hefner, C.A. No. H-03-5693 (S.D. Tex. Sept. 29, 2006).
TBOC § 21.401; TBCA art. 2.31; and DEL. CODE ANN. tit. 8, § 141(a) (title 8 of the Delaware Code Annotated to be
hereinafter referred to as the “DGCL”).
Although the DGCL “does not prescribe in detail formal requirements for board meetings, the meetings do have to take
place [and] the mere fact that directors are gathered together does not a meeting make;” where there is no formal call to
the meeting and no vote taken, directors caucusing on their own and informally deciding among themselves how they
would proceed is like simply polling board members and “does not constitute a valid meeting or effective corporate
action.” Fogel v. U.S. Energy Systems Inc., No. 3271-CC (Del. Ch. Dec. 13, 2007).
The Fogel case arose in the context of a confrontation between three independent directors and the Board chairman
they sought to terminate (there were no other directors). The opinion by Chancellor William B. Chandler III recounted
that U.S. Energy “was in precarious financial condition” when Fogel was hired in 2005 to become CEO and a director
(ultimately, becoming Board chairman as well). Fogel’s initial tenure with the company was successful, but trouble
soon followed.
Upon learning of the entity’s financial woes, the Board decided at a June 14, 2006 meeting to hire a financial adviser or
restructuring official. The Board resolved to meet again on June 29 to interview potential candidates, but prior to that
meeting, the three independent directors communicated with one another about Fogel’s performance, ultimately
deciding that he would have to be terminated.
On the morning of June 29, they met in the law offices of their outside counsel and decided to fire Fogel. The three
directors then confronted Fogel in the Boardroom where the meeting was to take place, advised that they had lost faith
in him, and stated that they wanted him to resign as chairman and CEO. Fogel challenged the directors’ ability to fire
him and ultimately refused to resign, whereupon an independent director informed him that he was terminated.
Thereafter, on July 1, Fogel e-mailed the company’s general counsel and the board calling for a special shareholder
meeting for the purpose of voting on the removal of the other directors and electing their replacements. Later that day,
during a scheduled Board meeting, the Board formally passed a resolution terminating Fogel and thereafter ignored
Fogel’s call for a special meeting. Litigation ensued.
The issue in the case was whether Fogel was still CEO and Board chairman at the time he called for a special meeting
of shareholders. If the independent directors’ June 29 decision to fire Fogel constituted formal Board action, Fogel was
terminated before July 1 and lacked authority to call for a special meeting of shareholders. If not, Fogel remained
Board chairman and CEO until the July 1 formal resolution, which passed after Fogel called for the special meeting of
shareholders.
The Court noted that under DGCL § 141 termination of the chairman and CEO required Board “action, and the board
can only take action by means of a vote at a properly constituted meeting. … Although the [DGCL] does not prescribe
in detail formal requirements for board meetings, the meetings do have to take place.” In this case, the Chancellor
concluded that the June 29 confrontation between Fogel and the independent directors did not constitute a meeting.
The mere fact that directors were gathered and caucusing did not constitute a meeting as there was no formal call to the
meeting and there was no vote whatsoever.
“Simply ‘polling board members does not constitute a valid meeting or effective corporation action,’” the Chancellor
instructed. In any event, the Court added, if the meeting did occur, it would be void because the independent
directors—who kept secret their plan to fire Fogel—obtained Fogel’s attendance by deception. Although Fogel lacked
the votes needed to protect his employment, the Chancellor reasoned that had he known of the defendants’ plans
beforehand, “he could have exercised his right under the bylaws to call for a special meeting before the board met. The
3
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fiduciary duty of a director has been characterized as including duties of loyalty (including good
faith), care and obedience.11 In Delaware, the fiduciary duties include those of loyalty (including
good faith) and care.12 Importantly, the duties of due care, good faith and loyalty give rise to a
fourth important precept of fiduciary obligation under Delaware law – namely, the so-called
“duty of disclosure,” which requires the directors disclose full and accurate information when
communicating with stockholders.13 The term “duty of disclosure,” however, is somewhat of a
misnomer because no separate duty of disclosure actually exists. Rather, as indicated, the
fiduciary obligations of directors in the disclosure context involve a contextually-specific
application of the duties of care and loyalty.14
B.
Applicable Law.
“The internal affairs doctrine is a conflict of laws principle which recognizes that only
one State should have the authority to regulate a corporation’s internal affairs,”15 and “under the
commerce clause a state ‘has no interest in regulating the internal affairs of foreign
corporations.’”16 “Internal corporate affairs” are “those matters which are peculiar to the
relationships among or between the corporation and its current officers, directors, and
shareholders,” and are to be distinguished from matters which are not unique to corporations:
It is essential to distinguish between acts which can be performed by both
corporations and individuals, and those activities which are peculiar to the
corporate entity. Corporations and individuals alike enter into contracts, commit
11
12
13
14
15
16
deception renders the meeting and any action taken there void.” Accordingly, Fogel was still authorized on July 1 to
call for a special shareholder meeting, and corporation and its Board were ordered to hold such a meeting.
The Chancellor disagreed with the independent directors’ argument that even if the June 29 meeting and termination
were deficient, “any problems were cured” when the Board ratified its June 29 actions during the July 1 meeting,
holding: “When a corporate action is void, it is invalid ab initio and cannot be ratified later.” The Chancellor said the
action taken at the July 1 meeting may have resulted in Fogel’s termination, but the termination was effective only as of
that vote. By that time, however, Fogel already had issued his call for a special shareholders’ meeting.
Nonetheless, the Court concluded that the independent directors ignoring Fogel’s call for a special meeting was not to
thwart a shareholder vote, but because they “believed in good faith” that Fogel had been terminated and thus “lacked
the authority to call for such a meeting.” Accordingly, the Chancellor held that the three independent directors did not
breach their fiduciary obligations of loyalty.
Gearhart Industries, Inc. v. Smith International, Inc., 741 F.2d 707, 719 (5th Cir. 1984).
While good faith “may be described colloquially as part of a “triad” of fiduciary duties that includes the duties of care
and loyalty,” the Delaware Supreme Court recently clarified the relationship of “good faith” to the duties of care and
loyalty, noting that “the obligation to act in good faith does not establish an independent fiduciary duty that stands on
the same footing as the duties of care and loyalty. Only the latter two duties, where violated, may directly result in
liability, whereas a failure to act in good faith may do so, but indirectly. The second doctrinal consequence is that the
fiduciary duty of loyalty is not limited to cases involving a financial or other cognizable fiduciary conflict of interest. It
also encompasses cases where the fiduciary fails to act in good faith.” Stone v. Ritter, 911 A.2d 362, 2006 WL
3169168 (Del. 2006). See notes 211-240 and related text, infra.
“Once [directors] traveled down the road of partial disclosure … an obligation to provide the stockholders with an
accurate, full, and fair characterization” attaches. Arnold v. Society for Savings Bancorp, Inc., 650 A.2d 1270, 1280
(Del. 1994); see also In re MONY Group S’holder Litig., 852 A.2d 9, 24-25 (Del. Ch. 2004) (“[O]nce [directors] take it
upon themselves to disclose information, that information must not be misleading.”).
Malone v. Brincat, 722 A.2d 5, 10 (Del 1998) (“[W]hen directors communicate with stockholders, they must recognize
their duty of loyalty to do so with honesty and fairness”); see notes 222-232 and related text, infra.
Edgar v. MITE Corp., 457 U.S. 624, 645 (1982).
McDermott, Inc. v. Lewis, 531 A.2d 206, 217 (Del. 1987); Frederick Tung, Before Competition: Origins of the Internal
Affairs Doctrine, 32 J. CORP. L. 33 (Fall 2006).
4
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torts, and deal in personal and real property. Choice of law decisions relating to
such corporate activities are usually determined after consideration of the facts of
each transaction. The internal affairs doctrine has no applicability in these
situations.17
The internal affairs doctrine in Texas mandates that courts apply the law of a
corporation’s state of incorporation in adjudications regarding director fiduciary duties.18
Delaware also subscribes to the internal affairs doctrine.19
17
18
19
Id. at 215 (citing Edgar, 457 U.S. at 645).
TBOC §§ 1.101-1.105; TBCA art. 8.02; TMCLA art. 1302-1.03; Hollis v. Hill, 232 F.3d 460 (5th Cir. 2000); Gearhart,
741 F.2d at 719; A. Copeland Enterprises, Inc. v. Guste, 706 F. Supp. 1283, 1288 (W.D. Tex. 1989).
See VantagePoint Venture Partners v. Examen, Inc., 871 A.2d 1108 (Del. 2005), in which the Delaware Supreme Court
considered whether a class of preferred stock would be entitled to vote as a separate class on the approval of a merger
agreement and ruled that Delaware law, rather than California law, governed and did not require the approval of the
holders of the preferred stock voting separately as a class for approval of the merger. In reaching that conclusion, the
Court held that the DGCL exclusively governs the internal corporate affairs of a Delaware corporation and that Section
2115 of the California Corporations Code, which requires a corporation with significant California contacts (sometimes
referred to as a “quasi-California corporation”) to comply with certain provisions of the California Corporations Code
even if the corporation is incorporated in another state, such as Delaware, is unconstitutional and, as a result of
Delaware rather than California law governing, the approval of the merger did not require the approval of the holders of
the preferred stock voting separately as a class.
Section 2115 of the California Corporations Code provides that, irrespective of the state of incorporation, the articles of
incorporation of a foreign corporation are deemed amended to conform to California law if (i) more than 50% of its
business (as defined) was derived from California during its last fiscal year and (ii) more than 50% of its outstanding
voting securities are held by persons with California addresses. Section 1201 of the California Corporations Code
requires that the principal terms of a merger be approved by the outstanding shares of each class.
Under Examen’s certificate of incorporation and Delaware law, a proposed merger of Examen with an unrelated
corporation required only the affirmative vote of the holders of a majority of the outstanding shares of common stock
and preferred stock, voting together as a single class. The holders of Examen’s preferred stock did not have enough
votes to block the merger if their shares were voted as a single class with the common stock. Thus they sued in
Delaware to block the merger based on the class vote requirements of the California statute.
Under Delaware law, however, holders of preferred stock are not entitled to vote as a class on a merger, even though
the merger effects an amendment to the certificate of incorporation that would have to be approved by a class vote if
the amendment were effected directly by an amendment to the certificate of incorporation, unless the certificate of
incorporation expressly requires a class vote to approve a merger. DGCL § 242(b)(2) provides generally with respect
to amendments to certificates of incorporation that the “holders of the outstanding shares of a class shall be entitled to
vote as a class upon a proposed amendment, whether or not entitled to vote thereon by the certificate of incorporation,
if the amendment would . . . alter or change the powers, preferences, or special rights of the shares of such class so as to
affect them adversely.” In Warner Communications Inc. v. Chris-Craft Indus., Inc., 583 A.2d 962 (Del. Ch. 1989), the
provision of the Warner certificate of incorporation at issue required a two-thirds class vote of the preferred stock to
amend, alter or repeal any provision of the certificate of incorporation if such action adversely affected the preferences,
rights, powers or privileges of the preferred stock. Warner merged with a Time subsidiary and was the surviving
corporation. In the merger, the Warner preferred stock was converted into Time preferred stock and the Warner
certificate of incorporation was amended to delete the terms of the preferred stock. The Chancery Court rejected the
argument that holders of the preferred stock were entitled to a class vote on the merger, reasoning that any adverse
effect on the preferred stock was caused not by an amendment of the terms of the stock, but solely by the conversion of
the stock into a new security in the merger pursuant to DGCL § 251. The Chancery Court also reasoned that the
language of the class vote provision at issue was similar to DGCL § 242 and did not expressly apply to mergers. See
Sullivan Money Mgmt., Inc. v. FLS Holdings, Inc., Del. Ch., C.A. No. 12731 (Nov. 20, 1992), aff’d, 628 A.2d 84 (Del.
1993) (where the certificate of incorporation required a class vote of the preferred stockholders for the corporation to
“change, by amendment to the Certificate of incorporation . . . or otherwise,” the terms and provisions of the preferred
stock, the Court held that “or otherwise” cannot be interpreted to mean merger in the context of a reverse triangular
merger in which the preferred stock was converted into cash but the corporation survived); see also Matulich v. Aegis
Communications Group, Inc., ____ A.2d ____ (Del. Jan. 15, 2008) (where certificate of designation of preferred stock
provided that holders of the preferred stock had no voting rights but had the right of approval and consent prior to any
merger, the holders of the preferred stock did not have any statutory right to vote on a merger, but had only a
5
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The Delaware Code subjects directors of Delaware corporations to personal jurisdiction
in the Delaware Court of Chancery over claims for violation of a duty in their capacity as
directors of a Delaware corporation.20 Texas does not have a comparable statute.
20
distinguishable contractual right to approve of and consent to mergers; thus since plaintiff’s preferred stock was not
entitled to vote on the merger, the holder of over 90% of the stock entitled to vote on the merger could approve a short
form merger under DGCL § 253 and does not have to establish the entire fairness of the merger). In contrast, in Elliott
Assocs. v. Avatex Corp., 715 A.2d 843 (Del. 1998), the certificate of incorporation provision expressly gave preferred
stockholders a class vote on the “amendment, alteration or repeal, whether by merger, consolidation or otherwise” of
provisions of the certificate of incorporation so as to adversely affect the rights of the preferred stock, and preferred
stock was converted into common stock of the surviving corporation of a merger. The Court in Elliott, for purposes of
its opinion, assumed that the preferred stock was adversely affected, distinguished Warner because the charter
contained the “whether by merger, consolidation or otherwise” language, and held that the preferred stock had a right to
a class vote on the merger because the adverse effect was caused by the repeal of the charter and the stock conversion.
The Court in Elliott commented that the “path for future drafters to follow in articulating class vote provisions is clear”:
“When a certificate (like the Warner certificate or the Series A provisions here) grants only the right to vote on an
amendment, alteration or repeal, the preferred have no class vote in a merger. When a certificate (like the First Series
Preferred certificate here) adds the terms ‘whether by merger, consolidation or otherwise’ and a merger results in an
amendment, alteration or repeal that causes an adverse effect on the preferred, there would be a class vote.” Id. at 855.
See Benchmark Capital Partners IV, L.P. v. Vague, 2002 Del. Ch. LEXIS 90, at *25 (Del. Ch. July 15, 2002) (“[A
court’s function in ascertaining the rights of preferred stockholders] is essentially one of contract interpretation.”), aff’d
sub nom. Benchmark Capital Partners IV, L.P. v. Juniper Fin. Corp., 822 A.2d 396 (Del. 2003); and Watchmark Corp.
v. Argo Global Capital, LLC, et al, C.A. 711-N (Del. Ch. November 4, 2004). (“Duties owed to preferred stockholders
are ‘primarily . . . contractual in nature,’ involving the ‘rights and obligations created contractually by the certificate of
designation.’ If fiduciary duties are owed to preferred stockholders, it is only in limited circumstances. Whether a
given claim asserted by preferred stockholders is governed by contractual or fiduciary duty principles, then, depends on
whether the dispute arises from rights and obligations created by contract or from ‘a right or obligation that is not by
virtue of a preference but is shared equally with the common.’”)
Under Texas law and unless the charter otherwise provides, approval of a merger or other fundamental business
transaction requires the affirmative vote of the holders of two-thirds of (i) all of the corporation’s outstanding shares
entitled to vote voting as a single class and (ii) each class entitled to vote as a class or series thereon. TBOC § 21.457;
TBCA art. 5.03.F. Separate voting by a class or series of shares of a corporation is required by TBOC § 21.458 and
TBCA art. 5.03(E) for approval of a plan of merger only if (a) the charter so provides or (b) the plan of merger contains
a provision that if contained in an amendment to the charter would require approval by that class or series under TBOC
§ 21.364 or TBCA art. 4.03, which generally require class voting on amendments to the charter which change the
designations, preferences, limitations or relative rights or a class or series or otherwise affect the class or series in
specified respects. Unless a corporation’s charter provides otherwise, the foregoing Texas merger approval
requirements (but not the charter amendment requirements) are subject to exceptions for (a) mergers in which the
corporation will be the sole survivor and the ownership and voting rights of the shareholders are not substantially
impaired (TBOC § 21.459(a); TBCA art. 5.03.G), (b) mergers affected to create a holding company (TBOC §§ 10.005,
21.459(b); TBCA art. 5.03.H – 5.03.K), and (c) short form mergers (TBOC §§ 10.006, 21.459(b); TBCA art. 5.16.A –
5.16.F).
The California courts, however, tend to uphold California statutes against internal affairs doctrine challenges. See
Friese v. Superior Court of San Diego County, 36 Cal. Rptr. 3d 558 (Cal. Ct. App. 2005), in which a California court
allowed insider trading claims to be brought against a director of a California based Delaware corporation and wrote
“while we agree that the duties officers and directors owe a corporation are in the first instance defined by the law of
the state of incorporation, such duties are not the subject of California’s corporate securities laws in general or
[Corporate Securities Law] section 25502.5 in particular…. Because a substantial portion of California’s marketplace
includes transactions involving securities issued by foreign corporations, the corporate securities laws have been
consistently applied to such transactions.”
10 Del. C. § 3114(a) provides (emphasis added):
Every nonresident of this State who after September 1, 1977, accepts election or appointment as a
director, trustee or member of the governing body of a corporation organized under the laws of this State
or who after June 30, 1978, serves in such capacity, and every resident of this State who so accepts
election or appointment or serves in such capacity and thereafter removes residence from this State shall,
by such acceptance or by such service, be deemed thereby to have consented to the appointment of the
registered agent of such corporation (or, if there is none, the Secretary of State) as an agent upon whom
service of process may be made in all civil actions or proceedings brought in this State, by or on behalf
6
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C.
Fiduciary Duties in Texas Cases.
The Fifth Circuit stated in Gearhart that under Texas law “[t]hree broad duties stem from
the fiduciary status of corporate directors; namely the duties of obedience, loyalty, and due care,”
and commented that (i) the duty of obedience requires a director to avoid committing ultra vires
acts, i.e., acts beyond the scope of the authority of the corporation as defined by its articles of
incorporation or the laws of the state of incorporation, (ii) the duty of loyalty dictates that a
director must act in good faith and must not allow his personal interests to prevail over the
interests of the corporation, and (iii) the duty of due care requires that a director must handle his
corporate duties with such care as an ordinarily prudent man would use under similar
circumstances.21 Good faith under Gearhart is an element of the duty of loyalty. Gearhart
remains the seminal case for defining the fiduciary duties of directors in Texas, although there
are subsequent cases that amplify Gearhart as they apply it in the context of lawsuits by the
Federal Deposit Insurance Corporation (“FDIC”) and the Resolution Trust Company (“RTC”)
arising out of failed financial institutions.22 Many Texas fiduciary duty cases arise in the context
of closely held corporations.23
1.
Loyalty.
a.
Good Faith.
The duty of loyalty in Texas is a duty that dictates that the director act in good faith and
not allow his personal interest to prevail over that of the corporation.24 The good faith of a
director will be determined on whether the director acted with an intent to confer a benefit to the
corporation.25 Whether there exists a personal interest by the director will be a question of fact.26
21
22
23
24
25
26
of, or against such corporation, in which such director, trustee or member is a necessary or proper party,
or in any action or proceeding against such director, trustee or member for violation of a duty in such
capacity, whether or not the person continues to serve as such director, trustee or member at the time
suit is commenced. Such acceptance or service as such director, trustee or member shall be a
signification of the consent of such director, trustee or member that any process when so served shall be
of the same legal force and validity as if served upon such director, trustee or member within this State
and such appointment of the registered agent (or, if there is none, the Secretary of State) shall be
irrevocable.
Gearhart, 741 F.2d at 719-721; McCollum v. Dollar, 213 S.W. 259 (Tex. Comm’n App. 1919, holding approved); see
Landon v. S&A Marketing Group, Inc., 82 S.W.2d 3rd 666 (Tx. App. Eastland 2002), which quoted and repeated the
summary of Texas fiduciary duty principles from Gearhart.
See, e.g., FDIC v. Harrington, 844 F. Supp. 300 (N.D. Tex. 1994).
See Flanary v. Mills, 150 S.W.3d 785 (Tex. App. – Austin 2004) (uncle and nephew incorporated 50%/50% owned
roofing business, but never issued stock certificates or had board or shareholder meetings; uncle used corporation’s
banking account as his own, told nephew business doing poorly and sent check to nephew for $7,500 as his share of
proceeds of business for four years; court held uncle liable for breach of fiduciary duties that we would label loyalty
and candor.)
Gearhart, 741 F.2d at 719.
International Bankers Life Insurance Co. v. Holloway, 368 S.W.2d 567 (Tex. 1967), in which the court indicated that
good faith conduct requires a showing that the directors had “an intent to confer a benefit to the corporation.”
Id. at 578.
7
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b.
Self-Dealing Transactions.
In general, a director will not be permitted to derive a personal profit or advantage at the
expense of the corporation and must act solely with an eye to the best interest of the corporation,
unhampered by any pecuniary interest of his own.27 The court in Gearhart summarized Texas
law with respect to the question of whether a director is “interested” in the context of self-dealing
transactions:
A director is considered “interested” if he or she (1) makes a personal profit from
a transaction by dealing with the corporation or usurps a corporate opportunity
. . .; (2) buys or sells assets of the corporation . . .; (3) transacts business in his
director’s capacity with a second corporation of which he is also a director or
significantly financially associated . . .; or (4) transacts business in his director’s
capacity with a family member.28
c.
Oversight.
In Texas an absence of good faith may also be found in situations where there is a severe
failure of director oversight. In FDIC v. Harrington,29 a federal district court applying Texas law
held that there is an absence of good faith when a board “abdicates [its] responsibilities and fails
to exercise any judgment.”
2.
Care (including business judgment rule).
The duty of care in Texas requires the director to handle his duties with such care as an
ordinarily prudent man would use under similar circumstances. In performing this obligation,
the director must be diligent and informed and exercise honest and unbiased business judgment
in pursuit of corporate interests.30
In general, the duty of care will be satisfied if the director’s actions comport with the
standard of the business judgment rule. The Fifth Circuit stated in Gearhart that, in spite of the
requirement that a corporate director handle his duties with such care as an ordinarily prudent
man would use under similar circumstances, Texas courts will not impose liability upon a
noninterested corporate director unless the challenged action is ultra vires or is tainted by fraud.
In a footnote in the Gearhart decision, the Fifth Circuit stated:
The business judgment rule is a defense to the duty of care. As such, the Texas
business judgment rule precludes judicial interference with the business judgment
27
28
29
30
A. Copeland Enterprises, 706 F. Supp. at 1291; Milam v. Cooper Co., 258 S.W.2d 953 (Tex. Civ. App. — Waco 1953,
writ ref’d n.r.e.); see Kendrick, The Interested Director in Texas, 21 Sw. L.J. 794 (1967).
Gearhart, 741 F.2d at 719-20 (citations omitted); see Landon v. S&A Marketing Group, Inc., 82 S.W.2d 3rd 666 (Tx.
App. Eastland 2002), which cited and repeated the “independence” test articulated in Gearhart. See also notes 157-163
and related text, infra.
844 F. Supp. 300 (N.D. Tex. 1994).
Gearhart, 741 F.2d at 719; McCollum v. Dollar, 213 S.W. 259 (Tex. Comm’n App. 1919, holding approved).
8
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of directors absent a showing of fraud or an ultra vires act. If such a showing is
not made, then the good or bad faith of the directors is irrelevant.31
In applying the business judgment rule in Texas, the courts in Gearhart and other recent
cases have quoted from the early Texas decision of Cates v. Sparkman,32 as setting the standard
for judicial intervention in cases involving duty of care issues:
[I]f the acts or things are or may be that which the majority of the company have a
right to do, or if they have been done irregularly, negligently, or imprudently, or
are within the exercise of their discretion and judgment in the development or
prosecution of the enterprise in which their interests are involved, these would not
constitute such a breach of duty, however unwise or inexpedient such acts might
be, as would authorize interference by the courts at the suit of a shareholder.33
In Gearhart the Court commented that “[e]ven though Cates was decided in 1889, and
despite the ordinary care standard announced in McCollum v. Dollar, supra, Texas courts to this
day will not impose liability upon a noninterested corporate director unless the challenged action
is ultra vires or is tainted by fraud.”34
Neither Gearhart nor the earlier Texas cases on which it relied referenced “gross
negligence” as a standard for director liability. If read literally, the business judgment rule
articulated in the case would protect even grossly negligent conduct. Federal district court
decisions in FDIC and RTC initiated cases, however, have declined to interpret Texas law this
broadly and have held that the Texas business judgment rule does not protect “any breach of the
duty of care that amounts to gross negligence” or “directors who abdicate their responsibilities
and fail to exercise any judgment.”35 These decisions “appear to be the product of the special
treatment banks may receive under Texas law” and may not be followed to hold directors “liable
for gross negligence under Texas law as it exists now” in other businesses.36
Gross negligence in Texas is defined as “that entire want of care which would raise the
belief that the act or omission complained of was the result of a conscious indifference to the
right or welfare of the person or persons to be affected by it.”37 In Harrington, the Court
31
32
33
34
35
36
37
Gearhart, 741 F.2d at 723 n.9.
11 S.W. 846 (1889).
Id. at 849.
Gearhart, 741 F.2d at 721.
FDIC v. Harrington, 844 F. Supp. 300, 306 (N.D. Tex. 1994); see also FDIC v. Schreiner, 892 F.Supp. 869 (W.D. Tex.
1995); FDIC v. Benson, 867 F. Supp. 512 (S.D. Tex. 1994); RTC v. Acton, 844 F. Supp, 307, 314 (N.D. Tex. 1994);
RTC v. Norris, 830 F. Supp. 351, 357-58 (S.D. Tex. 1993); FDIC v. Brown, 812 F. Supp. 722, 726 (S.D. Tex. 1992); cf.
RTC v. Miramon, 22 F.3d 1357 (5th Cir. 1994) (followed Harrington analysis of Section 1821(K) of the Financial
Institutions Reform, Recovery and Enforcement Act (“FIRREA”) which held that federal common law of director
liability did not survive FIRREA and applied Texas’ gross negligence standard for financial institution director liability
cases under FIRREA).
Floyd v. Hefner, 2006 WL 2844245 (S.D. Tex. Sept. 29, 2006).
Burk Royalty Co. v. Walls, 616 S.W.2d 911, 920 (Tex. 1981) (citing Missouri Pacific Ry. v. Shuford, 72 Tex. 165, 10
S.W. 408, 411 (1888)).
9
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concluded “that a director’s total abdication of duties falls within this definition of gross
negligence.”38
The business judgment rule in Texas does not necessarily protect a director with respect
to transactions in which he is “interested.” It simply means that the action will have to be
challenged on duty of loyalty rather than duty of care grounds.39
Directors may “in good faith and with ordinary care, rely on information, opinions,
reports or statements, including financial statements and other financial data,” prepared by
officers or employees of the corporation, counsel, accountants, investment bankers or “other
persons as to matters the director reasonably believes are within the person’s professional or
expert competence.”40
3.
Other (obedience).
The duty of obedience in Texas requires a director to avoid committing ultra vires acts,
i.e., acts beyond the scope of the powers of the corporation as defined by its articles of
incorporation and Texas law.41 An ultra vires act may be voidable under Texas law, but the
director will not be held personally liable for such act unless the act is in violation of a specific
statute or against public policy.
The RTC’s complaint in RTC v. Norris42 asserted that the directors of a failed financial
institution breached their fiduciary duty of obedience by failing to cause the institution to
adequately respond to regulatory warnings: “The defendants committed ultra vires acts by
ignoring warnings from [regulators], by failing to put into place proper review and lending
procedures, and by ratifying loans that did not comply with state and federal regulations and
Commonwealth’s Bylaws.”43 In rejecting this RTC argument, the court wrote:
The RTC does not cite, and the court has not found, any case in which a
disinterested director has been found liable under Texas law for alleged ultra vires
acts of employees, absent pleadings and proof that the director knew of or took
part in the act, even where the act is illegal.
....
Under the business judgment rule, Texas courts have refused to impose
personal liability on corporate directors for illegal or ultra vires acts of corporate
agents unless the directors either participated in the act or had actual knowledge
of the act . . . .44
38
39
40
41
42
43
44
844 F. Supp. at 306 n.7.
Gearhart, 741 F.2d at 723, n.9.
TBCA art. 2.41D.
Gearhart, 741 F.2d at 719.
830 F. Supp. 351 (S.D. Tex. 1993).
Norris, 830 F. Supp. at 355.
Id.
10
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D.
Fiduciary Duties in Delaware Cases.
1.
Loyalty.
a.
Conflicts of Interest.
In Delaware, the duty of loyalty mandates “that there shall be no conflict between duty
and self-interest.”45 It demands that the best interests of the corporation and its stockholders take
precedence over any personal interest or bias of a director that is not shared by stockholders
generally.46 The Delaware Court of Chancery has summarized the duty of loyalty as follows:
Without intending to necessarily cover every case, it is possible to say
broadly that the duty of loyalty is transgressed when a corporate fiduciary,
whether director, officer or controlling shareholder, uses his or her corporate
office or, in the case of a controlling shareholder, control over corporate
machinery, to promote, advance or effectuate a transaction between the
corporation and such person (or an entity in which the fiduciary has a substantial
economic interest, directly or indirectly) and that transaction is not substantively
fair to the corporation. That is, breach of loyalty cases inevitably involve
conflicting economic or other interests, even if only in the somewhat diluted form
present in every ‘entrenchment’ case.47
Importantly, conflicts of interest do not per se result in a breach of the duty of loyalty.
Rather, it is the manner in which an interested director handles a conflict and the processes
invoked to insure fairness to the corporation and its stockholders that will determine the
propriety of the director’s conduct and the validity of the particular transaction. Moreover, the
Delaware courts have emphasized that only material personal interests or influences will imbue a
transaction with duty of loyalty implications.
The duty of loyalty may be implicated in connection with numerous types of corporate
transactions, including, for example, the following: contracts between the corporation and
directors or entities in which directors have a material interest; management buyouts; dealings by
a parent corporation with a subsidiary; corporate acquisitions and reorganizations in which the
interests of a controlling stockholder and the minority stockholders might diverge; usurpations of
corporate opportunities; competition by directors or officers with the corporation; use of
corporate office, property or information for purposes unrelated to the best interest of the
corporation; insider trading; and actions that have the purpose or practical effect of perpetuating
directors in office. In Delaware, a director can be found guilty of a breach of duty of loyalty by
approving a transaction in which the director did not personally profit, but did approve a
45
46
47
Guth v. Loft, 5 A.2d 503, 510 (Del. 1939).
Cede & Co. v. Technicolor, Inc., 634 A.2d 345, 361 (Del. 1993) (“Technicolor I”). See notes 157-163 and related text,
infra.
Solash v. Telex Corp., 1988 WL 3587 at *7 (Del. Ch. Jan. 19, 1988). Some of the procedural safeguards typically
invoked to assure fairness in transactions involving Board conflicts of interest are discussed in more detail below, in
connection with the entire fairness standard of review.
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transaction that benefited the majority stockholder to the detriment of the minority
stockholders.48
b.
Good Faith.
Good faith is far from a new concept in Delaware fiduciary duty law. Good faith long
was viewed by the Delaware courts (and still is viewed by many commentators) as an integral
component of the duties of care and loyalty. Indeed, in one of the early, landmark decisions
analyzing the contours of the duty of loyalty, the Delaware Supreme Court observed that “no
hard and fast rule can be formatted” for determining whether a director has acted in “good
faith.”49 While that observation remains true today, the case law and applicable commentary
provide useful guidance regarding some of the touchstone principles underlying the duty of good
faith.50
The duty of good faith was recognized as a distinct directorial duty in Cede & Co. v.
Technicolor, Inc.51 The duty of good faith requires that directors act honestly, in the best interest
of the corporation, and in a manner that is not knowingly unlawful or contrary to public policy.
While the Court’s review requires it to examine the Board’s subjective motivation, the Court will
utilize objective facts to infer such motivation. Like a duty of care analysis, such review likely
will focus on the process by which the Board reached the decision under review. Consistent with
earlier articulations of the level of conduct necessary to infer bad faith (or irrationality), more
recent case law suggests that only fairly egregious conduct (such as a knowing and deliberate
indifference to a potential risk of harm to the corporation) will rise to the level of “bad faith.”52
The impetus for an increased focus on the duty of good faith is the availability of
damages as a remedy against directors who are found to have acted in bad faith. DGCL
§ 102(b)(7) authorizes corporations to include in their certificates of incorporation a provision
eliminating or limiting directors’ liability for breaches of the fiduciary duty of care. However,
DGCL § 102(b)(7) also expressly provides that directors cannot be protected from liability for
either actions not taken in good faith or breaches of the duty of loyalty.53 A finding of a lack of
good faith has profound significance for directors not only because they may not be exculpated
from liability for such conduct, but also because a prerequisite to eligibility for indemnification
48
49
50
51
52
53
Crescent/Mach I Partners, L.P. v. Twiner, 846 A.2d 963, n. 50 (Del. Ch. 2000); Strassburger v. Earley, 752 A.2d 557,
581 (Del. Ch. 2000).
See Guth, 5 A.2d at 510.
See Stone v. Ritter, 911 A.2d 362, 2006 WL 3169168 (Del. 2006); In re The Walt Disney Co. Derivative Litig., 906
A.2d 27 (Del. 2006); John F. Grossbauer and Nancy N. Waterman, The (No Longer) Overlooked Duty of Good Faith
Under Delaware Law, VIII “Deal Points” No. 2 of 6 (The Newsletter of the ABA Business Law Section Committee on
Negotiated Acquisitions, No. 2, Summer 2003).
634 A.2d 345, 361 (Del. 1993) (Technicolor I).
In re the Walt Disney Company Derivative Litigation, 906 A.2d 27 (Del. 2006).
Specifically, DGCL § 102(b)(7) authorizes the inclusion in a certificate of incorporation of:
A provision eliminating or limiting the personal liability of a director to the corporation or its
stockholders for monetary damages for breach of fiduciary duty as a director, provided that such
provision shall not eliminate or limit the liability or a director: (i) For any breach of the director’s duty
of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in good faith or which
involve intentional misconduct or a knowing violation of law; (iii) under §174 of this title [dealing with
the unlawful payment of dividends or unlawful stock purchase or redemption]; or (iv) for any
transaction from which the director derived an improper personal benefit . . .
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under DGCL § 145 of the DGCL is that the directors who were unsuccessful in their litigation
nevertheless must demonstrate that they have acted “in good faith and in a manner the person
reasonably believed was in or not opposed to the best interests of the corporation.”54
Accordingly, a director who has breached the duty of good faith not only is exposed to personal
liability, but also may not be able to seek indemnification from the corporation for any judgment
obtained against her or for expenses incurred (unsuccessfully) litigating the issue of liability.55
Thus, in cases involving decisions made by directors who are disinterested and independent with
respect to a transaction (and, therefore, the duty of loyalty is not implicated), the duty of good
faith still provides an avenue for asserting claims of personal liability against the directors.
Moreover, these claims, if successful, create barriers to indemnification of amounts paid by
directors in judgment or settlement.56
In Stone v. Ritter,57 the Delaware Supreme Court held that “good faith” is not a separate
fiduciary duty like the duties of care and loyalty, but rather is embedded in the duty of loyalty:
[F]ailure to act in good faith results in two additional doctrinal
consequences. First, although good faith may be described colloquially as part of
a “triad” of fiduciary duties that includes the duties of care and loyalty, the
obligation to act in good faith does not establish an independent fiduciary duty
that stands on the same footing as the duties of care and loyalty. Only the latter
two duties, where violated, may directly result in liability, whereas a failure to act
in good faith may do so, but indirectly. The second doctrinal consequence is that
the fiduciary duty of loyalty is not limited to cases involving a financial or other
cognizable fiduciary conflict of interest.
c.
Oversight/Caremark.
Directors also may be found to have violated the duty of loyalty when they fail to act in
the face of a known duty to act – i.e., they act in bad faith.58 In an important Delaware Chancery
Court decision on this issue, In re Caremark International, Inc. Derivative Litigation,59 the
settlement of a derivative action that involved claims that Caremark’s Board breached its
fiduciary duty to the company in connection with alleged violations by the company of antireferral provisions of Federal Medicare and Medicaid statutes was approved. In so doing, the
Court discussed the scope of a Board’s duty to supervise or monitor corporate performance and
stay informed about the business of the corporation as follows:
54
55
56
57
58
59
DGCL §§ 145(a) and (b).
In contrast, it is at least theoretically possible that a director who has been found to have breached his or her duty of loyalty
could be found to have acted in good faith and, therefore, be eligible for indemnification of expenses (and, in non-derivative
cases, amounts paid in judgment or settlement) by the corporation. See Blasius Industries, Inc. v. Atlas Corp., 564 A.2d
651 (Del. Ch. 1988) (directors found to have acted in good faith but nevertheless breached their duty of loyalty).
The availability of directors and officers liability insurance also may be brought into question by a finding of bad faith.
Policies often contain exclusions that could be cited by carriers as a basis for denying coverage.
911 A.2d 362, 2006 WL 3169168 (Del. 2006).
In Stone v. Ritter, 911 A.2d 362, 2006 WL 3169168 (Del. 2006), the Delaware Supreme Court held that “the
requirement to act in good faith is a subsidiary element, i.e., a condition, of the fundamental duty of loyalty.”
698 A.2d 959 (Del. Ch. 1996); see Regina F. Burch, Director Oversight and Monitoring: The Standard of Care and
The Standard of Liability Post-Enron, 6 Wyoming L.Rev. 482 (2006).
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[I]t would . . . be a mistake to conclude . . . that corporate boards may satisfy their
obligations to be reasonably informed concerning the corporation, without
assuring themselves that information and reporting systems exist in the
organization that are reasonably designed to provide to senior management and to
the board itself timely, accurate information sufficient to allow management and
the board, each within its scope, to reach informed judgments concerning both the
corporation’s compliance with law and its business performance.60
Stated affirmatively, “a director’s obligation includes a duty to attempt in good faith to
assure that a corporate information and reporting system, which the board concludes is adequate,
exists, and that failure to do so under some circumstances may . . . render a director liable.”61
While Caremark recognizes a cause of action for uninformed inaction, the holding is subject to
the following:
First, the Court held that “only a sustained or systematic failure of the board to exercise
oversight — such as an utter failure to attempt to assure a reasonable information and reporting
system exists — will establish the lack of good faith that is a necessary condition to liability.”62
It is thus not at all clear that a plaintiff could recover based on a single example of director
inaction, or even a series of examples relating to a single subject.
Second, Caremark noted that “the level of detail that is appropriate for such an
information system is a question of business judgment,”63 which indicates that the presence of an
existing information and reporting system will do much to cut off any derivative claim, because
the adequacy of the system itself will be protected.
Third, Caremark considered it obvious that “no rationally designed information system
. . . will remove the possibility” that losses could occur.64 As a result, “[a]ny action seeking
recovery for losses would logically entail a judicial determination of proximate cause.”65 This
holding indicates that a loss to the corporation is not itself evidence of an inadequate information
and reporting system. Instead, the court will focus on the adequacy of the system overall and
whether a causal link exists.66
The Caremark issue of a board’s systematic failure to exercise oversight was revisited by
the Seventh Circuit applying Illinois law in In re Abbott Laboratories Derivative Shareholders
60
61
62
63
64
65
66
698 A.2d at 970.
Id.
Id. at 971.
Id. at 970.
Id.
Id. at 970 n. 27.
See generally Eisenberg, Corporate Governance The Board of Directors and Internal Control, 19 CARDOZO L. REV.
237 (1997); Pitt, et al., Talking the Talk and Walking the Walk: Director Duties to Uncover and Respond to
Management Misconduct, 1005 PLI/CORP. 301, 304 (1997); Gruner, Director and Officer Liability for Defective
Compliance Systems: Caremark and Beyond, 995 PLI/CORP. 57, 64-70 (1997); Funk, Recent Developments in
Delaware Corporate Law: In re Caremark International Inc. Derivative Litigation: Director Behavior, Shareholder
Protection, and Corporate Legal Compliance, 22 DEL. J. CORP. L. 311 (1997).
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Litigation.67 Abbott involved a shareholders derivative suit against the health care corporation’s
directors, alleging breach of fiduciary duty and asserting that the directors were liable under state
law for harms resulting from a consent decree between the corporation and the Food and Drug
Administration (“FDA”). The consent decree had followed a six-year period during which the
FDA had given numerous notices to the corporation of violations of FDA manufacturing
regulations and imposed a $100 million fine, which resulted in a $168 million charge to earnings.
In reversing a district court dismissal of plaintiff’s complaint for failure to adequately plead that
demand upon the board of directors would be futile, the Seventh Circuit held that the complaints
raised reasonable doubt as to whether the directors’ actions were the product of a valid exercise
of business judgment, thus excusing demand, and were sufficient to overcome the directors’
exemption from liability contained in the certificate of incorporation, at least for purposes of
defeating the plaintiffs’ motion to dismiss. In so holding, the Seventh Circuit noted that the
complaint pled that the directors knew or should have known of the FDA noncompliance
problems and demonstrated bad faith by ignoring them for six years and not disclosing them in
the company’s SEC periodic reports during this period. The Court relied upon Delaware case
law and wrote:
[T]he facts support a reasonable assumption that there was a ‘sustained and
systematic failure of the board to exercise oversight,’ in this case intentional in
that the directors knew of the violations of law, took no steps in an effort to
prevent or remedy the situation, and that failure to take any action for such an
inordinate amount of time resulted in substantial corporate losses, establishing a
lack of good faith. We find that . . . the directors’ decision to not act was not
made in good faith and was contrary to the best interests of the company.68
The Seventh Circuit further held that the provision in the corporation’s articles of incorporation
limiting director liability69 would not be sufficient to sustain a motion to dismiss. It stated that in
a case such as this “[w]here the complaint sufficiently alleges a breach of fiduciary duties based
on a failure of the directors to act in good faith, bad faith actions present a question of fact that
cannot be determined at the pleading stage.”70 The court intimated that had the case involved a
simple allegation of breach of the duty of care and not bad faith, the liability limitation clause
might have led to a different result.71
67
68
69
70
71
325 F.3d 795 (7th Cir. 2003). The Abbott court distinguished Caremark on the grounds that in the latter, there was no
evidence indicating that the directors “conscientiously permitted a known violation of law by the corporation to occur,”
unlike evidence to the contrary in Abbott. Id. at 806 (quoting Caremark, 698 A.2d at 972). However, the Abbott court
nonetheless relied on Caremark language regarding the connection between a board’s systemic failure of oversight and
a lack of good faith. Abbott, 325 F.3d at 808-809.
Abbott, 325 F.3d at 809.
Abbott‘s certificate of incorporation included the following provision limiting director liability:
“A director of the corporation shall not be personally liable to the corporation or its shareholders for
monetary damages for breach of fiduciary duty as a director, except for liability (i) for any breach of the
director’s duty of loyalty to the corporation or its shareholders, (ii) for acts or omissions not in good
faith or that involve intentional misconduct or a knowing violation of law, (iii) under Section 8.65 of the
Illinois Business Corporation Act, or (iv) for any transaction from which the director derived an
improper personal benefit . . . .”
Id. at 810.
Id. at 811.
See id. at 810.
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In Saito v. McCall,72 a derivative suit was brought in the Delaware Chancery Court to
recover damages from the directors, senior officers, merger advisors and outside accountants of
each of HBO & Company (“HBOC”) (a healthcare software provider), McKesson Corporation
(“McKesson”) (a healthcare supply management company) and McKesson HBOC, Inc., the
surviving corporation (the “HBOC/McKesson Survivor”) in the 1999 merger of HBOC and
McKesson, alleging that: (1) HBOC’s directors and officers presided over a fraudulent
accounting scheme; (2) McKesson’s officers, directors and advisors uncovered HBOC’s
accounting improprieties during their due diligence, but nonetheless proceeded with the proposed
merger; and (3) the Company’s board did not act quickly enough to rectify the accounting fraud
following the merger. The Chancery Court dismissed most of the claims on procedural grounds,
with the notable exception of the claim against the Company’s directors alleging Caremark
violations.
In 1998, HBOC’s audit committee met with HBOC’s outside auditor to discuss HBOC’s
1997 audit and was informed that the 1997 audit was “high risk” and explained its concerns.
Although a subsequent SEC investigation established that HBOC was misapplying the generally
accepted accounting principles for financial reporting in the U.S. (“GAAP”), the auditors did not
inform the audit committee of this fact, and reported that there were no significant problems or
exceptions and that the auditors enjoyed the full cooperation of HBOC management.
During the summer of 1998, HBOC held discussions with McKesson regarding a
potential merger. McKesson engaged independent accountants and investment bankers to assist
it in evaluating the proposed merger. In a meeting with these advisors, McKesson’s board of
directors discussed the proposed merger and the due diligence issues that had surfaced, and first
learned of HBOC’s questionable accounting practices, although there was no indication that the
McKesson board actually knew of any of HBOC’s material accounting violations.
In October 1998, after a brief suspension of merger negotiations, the parties resumed
discussions and agreed upon a modified deal structure, but they did not resolve the issues related
to HBOC’s accounting practices. On October 16, 1998, with awareness of some of HBOC’s
accounting irregularities, McKesson’s board approved the merger and agreed to acquire HBOC
for $14 billion in McKesson stock. Following the effective time of the merger, the
HBOC/McKesson Survivor’s audit committee met with its advisors to discuss the transaction
and certain accounting adjustments to HBOC’s financial statements, which the audit committee
knew were insufficient to remedy the accounting improprieties that its auditors had previously
identified. The HBOC/McKesson Survivor took some remedial action in April 1999, when it
announced that it would restate its prior earnings downward and, a few months later, terminated
the senior management responsible for the accounting improprieties.
Thereafter, the plaintiffs brought a duty of oversight claim against the directors of the
HBOC/McKesson Survivor alleging, inter alia, that the Company directors had failed to (1)
correct HBOC’s false financial statements, (2) monitor the accounting practices of the Company,
(3) implement sufficient internal controls to guard against wrongful accounting practices that
were uncovered following the merger, and (4) disclose HBOC’s false financial statements. The
Court noted that under Caremark “a derivative plaintiff must allege facts constituting ‘a
72
C.A. No. 17132-NC, 2004 WL 3029876 (Del. Ch. Dec 20, 2004).
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sustained or systematic failure of the board to exercise oversight – such as an utter failure to
attempt to assure a reasonable information reporting system exists.’” To survive a motion to
dismiss, the plaintiff was required to show that the HBOC/McKesson Survivor board should
have known that the alleged accounting problems had occurred or were occurring and made no
good faith effort to rectify the accounting improprieties. Noting that the plaintiff was entitled to
the benefit of all reasonable inferences drawn from the applicable facts, the Court found that the
plaintiffs had alleged sufficient facts to infer that the boards of each of McKesson and HBOC –
members of which comprised the board of the HBOC/McKesson Survivor – knew, or should
have known, of HBOC’s accounting irregularities, noting that (i) HBOC’s audit committee
became aware of the accounting problems when it learned that its 1997 audit was “high risk” and
that the McKesson board learned of some of the problems during the July 1998 board meeting at
which due diligence issues were discussed, and (ii) the HBOC/McKesson Survivor’s audit
committee had considered, but failed to act swiftly upon, HBOC’s accounting problems. On
these facts, the Court concluded that the Company board knew or should have known that
HBOC’s accounting practices were unlawful and that, despite this knowledge, failed to take any
remedial action for several months. While noting that facts later adduced could prove that the
Company directors did not violate their duties under Caremark, the Court allowed the plaintiffs’
claim to survive a motion to dismiss.73
In Stone v. Ritter74 the Delaware Supreme Court affirmed Caremark as the standard for
assessing director oversight responsibility. Stone v. Ritter was a “classic Caremark claim”
arising out of a bank paying $50 million in fines and penalties to resolve government and
regulatory investigations pertaining principally to the failure of bank employees to file
Suspicious Activity Reports (“SARs”) as required by the Bank Secrecy Act (“BSA”) and various
anti money laundering regulations. The Chancery Court dismissed the plaintiffs’ derivative
complaint which alleged that “the defendants had utterly failed to implement any sort of
statutorily required monitoring, reporting or information controls that would have enabled them
to learn of problems requiring their attention.” In affirming the Chancery Court, the Supreme
Court commented, “[i]n this appeal, the plaintiffs acknowledge that the directors neither ‘knew
[n]or should have known that violations of law were occurring,’ i.e., that there were no ‘red
flags’ before the directors” and held “[c]onsistent with our opinion in In re Walt Disney Co.
Deriv Litig,75 … that Caremark articulates the necessary conditions for assessing director
oversight liability and … that the Caremark standard was properly applied to evaluate the
derivative complaint in this case.”
The Supreme Court explained the doctrinal basis for its holding as follows and, in so
doing, held that “good faith” is not a separate fiduciary duty:
As evidenced by the language quoted above, the Caremark standard for
so-called “oversight” liability draws heavily upon the concept of director failure
to act in good faith. That is consistent with the definition(s) of bad faith recently
approved by this Court in its recent Disney decision, where we held that a failure
73
74
75
The HBOC/McKesson Survivor’s certificate of incorporation included an exculpatory provision adopted pursuant to
DGCL § 102(b)(7). The parties did not raise, and the Court did not address, the impact of that provision.
911 A.2d 362; 2006 WL 3169168 (Del. 2006).
906 A.2d 27 (Del. 2006).
17
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to act in good faith requires conduct that is qualitatively different from, and more
culpable than, the conduct giving rise to a violation of the fiduciary duty of care
(i.e., gross negligence). In Disney, we identified the following examples of
conduct that would establish a failure to act in good faith:
A failure to act in good faith may be shown, for instance, where
the fiduciary intentionally acts with a purpose other than that of
advancing the best interests of the corporation, where the fiduciary
acts with the intent to violate applicable positive law, or where the
fiduciary intentionally fails to act in the face of a known duty to
act, demonstrating a conscious disregard for his duties. There may
be other examples of bad faith yet to be proven or alleged, but
these three are the most salient.
The third of these examples describes, and is fully consistent with, the lack
of good faith conduct that the Caremark court held was a “necessary condition”
for director oversight liability, i.e., “a sustained or systematic failure of the board
to exercise oversight – such as an utter failure to attempt to assure a reasonable
information and reporting system exists....” Indeed, our opinion in Disney cited
Caremark with approval for that proposition. Accordingly, the Court of Chancery
applied the correct standard in assessing whether demand was excused in this case
where failure to exercise oversight was the basis or theory of the plaintiffs’ claim
for relief.
It is important, in this context, to clarify a doctrinal issue that is critical to
understanding fiduciary liability under Caremark as we construe that case. The
phraseology used in Caremark and that we employ here – describing the lack of
good faith as a “necessary condition to liability” – is deliberate. The purpose of
that formulation is to communicate that a failure to act in good faith is not
conduct that results, ipso facto, in the direct imposition of fiduciary liability. The
failure to act in good faith may result in liability because the requirement to act in
good faith “is a subsidiary element[,]” i.e., a condition, “of the fundamental duty
of loyalty.” It follows that because a showing of bad faith conduct, in the sense
described in Disney and Caremark, is essential to establish director oversight
liability, the fiduciary duty violated by that conduct is the duty of loyalty.
This view of a failure to act in good faith results in two additional
doctrinal consequences. First, although good faith may be described colloquially
as part of a “triad” of fiduciary duties that includes the duties of care and loyalty,
the obligation to act in good faith does not establish an independent fiduciary duty
that stands on the same footing as the duties of care and loyalty. Only the latter
two duties, where violated, may directly result in liability, whereas a failure to act
in good faith may do so, but indirectly. The second doctrinal consequence is that
the fiduciary duty of loyalty is not limited to cases involving a financial or other
cognizable fiduciary conflict of interest. It also encompasses cases where the
fiduciary fails to act in good faith. As the Court of Chancery aptly put it in
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Guttman, “[a] director cannot act loyally towards the corporation unless she acts
in the good faith belief that her actions are in the corporation’s best interest.”
We hold that Caremark articulates the necessary conditions predicate for
director oversight liability: (a) the directors utterly failed to implement any
reporting or information system or controls; or (b) having implemented such a
system or controls, consciously failed to monitor or oversee its operations thus
disabling themselves from being informed of risks or problems requiring their
attention. In either case, imposition of liability requires a showing that the
directors knew that they were not discharging their fiduciary obligations. Where
directors fail to act in the face of a known duty to act, thereby demonstrating a
conscious disregard for their responsibilities, they breach their duty of loyalty by
failing to discharge that fiduciary obligation in good faith.
Stone v. Ritter was a “demand-excused” case in which the plaintiffs did not demand that
the directors commence the derivative action because allegedly the directors breached their
oversight duty and, as a result, faced a “substantial likelihood of liability” as a result of their
“utter failure” to act in good faith to put into place policies and procedures to ensure compliance
with regulatory obligations. The Court of Chancery found that the plaintiffs did not plead the
existence of “red flags” – “facts showing that the board ever was aware that company’s internal
controls were inadequate, that these inadequacies would result in illegal activity, and that the
board chose to do nothing about problems it allegedly knew existed.” In dismissing the
derivative complaint, the Court of Chancery concluded:
This case is not about a board’s failure to carefully consider a material corporate
decision that was presented to the board. This is a case where information was not
reaching the board because of ineffective internal controls.... With the benefit of
hindsight, it is beyond question that AmSouth’s internal controls with respect to
the Bank Secrecy Act and anti-money laundering regulations compliance were
inadequate. Neither party disputes that the lack of internal controls resulted in a
huge fine--$50 million, alleged to be the largest ever of its kind. The fact of those
losses, however, is not alone enough for a court to conclude that a majority of the
corporation’s board of directors is disqualified from considering demand that
AmSouth bring suit against those responsible.
The adequacy of the plaintiffs’ assertion that demand was excused turned on whether the
complaint alleged facts sufficient to show that the defendant directors were potentially personally
liable for the failure of non-director bank employees to file the required Suspicious Activity
Reports. In affirming the Chancery Court, the Supreme Court wrote:
For the plaintiffs’ derivative complaint to withstand a motion to dismiss,
“only a sustained or systematic failure of the board to exercise oversight--such as
an utter failure to attempt to assure a reasonable information and reporting system
exists--will establish the lack of good faith that is a necessary condition to
liability.” As the Caremark decision noted:
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Such a test of liability – lack of good faith as evidenced by
sustained or systematic failure of a director to exercise reasonable
oversight – is quite high. But, a demanding test of liability in the
oversight context is probably beneficial to corporate shareholders
as a class, as it is in the board decision context, since it makes
board service by qualified persons more likely, while continuing to
act as a stimulus to good faith performance of duty by such
directors.
The KPMG Report – which the plaintiffs explicitly incorporated by
reference into their derivative complaint – refutes the assertion that the directors
“never took the necessary steps ... to ensure that a reasonable BSA compliance
and reporting system existed.” KPMG’s findings reflect that the Board received
and approved relevant policies and procedures, delegated to certain employees
and departments the responsibility for filing SARs and monitoring compliance,
and exercised oversight by relying on periodic reports from them. Although there
ultimately may have been failures by employees to report deficiencies to the
Board, there is no basis for an oversight claim seeking to hold the directors
personally liable for such failures by the employees.
With the benefit of hindsight, the plaintiffs’ complaint seeks to equate a
bad outcome with bad faith. The lacuna in the plaintiffs’ argument is a failure to
recognize that the directors’ good faith exercise of oversight responsibility may
not invariably prevent employees from violating criminal laws, or from causing
the corporation to incur significant financial liability, or both, as occurred in
Graham, Caremark and this very case. In the absence of red flags, good faith in
the context of oversight must be measured by the directors’ actions “to assure a
reasonable information and reporting system exists” and not by second-guessing
after the occurrence of employee conduct that results in an unintended adverse
outcome. Accordingly, we hold that the Court of Chancery properly applied
Caremark and dismissed the plaintiffs’ derivative complaint for failure to excuse
demand by alleging particularized facts that created reason to doubt whether the
directors had acted in good faith in exercising their oversight responsibilities.
d.
Candor.
Where directors approve an SEC report that materially misrepresents the nature of
benefits provided by a corporation to its controlling shareholder, Chancellor Chandler explained
in 2007 that the directors may have breached their duties of candor and good faith, which are
subsets of the duty of loyalty:
When a Delaware corporation communicates with its shareholders, even in
the absence of a request for shareholder action, shareholders are entitled to honest
communication from directors, given with complete candor and in good faith.
Communications that depart from this expectation, particularly where it can be
shown that the directors involved issued their communication with the knowledge
that it was deceptive or incomplete, violate the fiduciary duties that protect
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shareholders. Such violations are sufficient to subject directors to liability in a
derivative claim.
***
Although directors have a responsibility to communicate with complete
candor in all shareholder communications, those that are issued with respect to a
request for shareholder action are especially critical. Where, as here, the directors
sought shareholder approval of an amendment to a stock option plan that could
potentially enrich themselves and their patron, their concern for complete and
honest disclosure should make Caesar appear positively casual about his wife’s
infidelity.76
In another case later in 2007, Chancellor Chandler further explained the contours of the
duty of candor:
Generally, directors have a duty to disclose all material information in
their possession to shareholders when seeking shareholder approval for some
corporate action. This “duty of disclosure” is not a separate and distinct fiduciary
duty, but it clearly does impose requirements on a corporation’s board. Those
requirements, however, are not boundless. Rather, directors need only disclose
information that is material, and information is material only “if there is a
substantial likelihood that a reasonable stockholder would consider it important in
deciding how to vote.” It is not sufficient that information might prove helpful; to
be material, it must “significantly alter the total mix of information made
available.” The burden of demonstrating a disclosure violation and of
establishing the materiality of requested information lies with the plaintiffs.77
2.
Care.
a.
Informed Action; Gross Negligence.
Directors have an obligation to inform themselves of all material information reasonably
available to them before making a business decision and, having so informed themselves, to act
with the requisite care in making such decision.78 Directors are not required, however, “to read
in haec verba every contract or legal document,”79 or to “know all particulars of the legal
documents [they] authorize[ ] for execution.”80 Although a director must act diligently and with
the level of due care appropriate to the particular situation, the Delaware courts have held that
76
77
78
79
80
In Re: INFOUSA, Inc. Shareholders Litigation, CA No. 1956-CC (Del. Ch. August 20, 2007); see infra notes 234 and
603 and related text.
In re CheckFree Corp., No. 3193-CC, 2007 WL 3262188 (Del. Ch. Nov. 1, 2007). See infra notes 104, 222-234, 330,
584-588, 595-609 and accompanying text.
See Technicolor I, 634 A.2d at 367; Van Gorkom, 488 A.2d at 872.
Smith v. Van Gorkom, 488 A.2d 858, 883 n.25.
Moran v. Household Int’l, Inc., 490 A.2d 1059, 1078 (Del. Ch.), aff’d, 500 A.2d 1346 (Del. 1985).
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action (or inaction) will constitute a breach of a director’s fiduciary duty of care only if the
director’s conduct rises to the level of gross negligence.81
Compliance with the duty of care requires active diligence. Accordingly, directors
should attend board meetings regularly; they should take time to review, digest, and evaluate all
materials and other information provided to them; they should take reasonable steps to assure
that all material information bearing on a decision has been considered by the directors or by
those upon whom the directors will rely; they should actively participate in board deliberations,
ask appropriate questions, and discuss each proposal’s strengths and weaknesses; they should
seek out the advice of legal counsel, financial advisors, and other professionals, as needed; they
should, where appropriate, reasonably rely upon information, reports, and opinions provided by
officers, experts or board committees; and they should take sufficient time (as may be dictated by
the circumstances) to reflect on decisions before making them. Action by unanimous written
consent ordinarily does not provide any opportunity for, or record of, careful Board
deliberations.82
b.
Inaction.
In many cases, of course, the directors’ decision may be not to take any action. To the
extent that decision is challenged, the focus will be on the process by which the decision not to
act was made. Where the failure to oversee or to act is so severe as to evidence a lack of good
faith, the failure may be found to be a breach of the duty of loyalty.83
c.
DGCL § 141(e) Reliance on Reports and Records.
The DGCL provides two important statutory protections to directors relating to the duty
of care. The first statutory protection is DGCL § 141(e) which provides statutory protection to
directors who rely in good faith upon corporate records or reports in connection with their efforts
to be fully informed, and reads as follows:
A member of the board of directors, or a member of any committee designated by
the board of directors, shall, in the performance of such member’s duties, be fully
protected in relying in good faith upon the records of the corporation and upon
such information, opinions, reports or statements presented to the corporation by
any of the corporation’s officers or employees, or committees of the board of
directors, or by any other person as to matters the member reasonably believes are
within such other person’s professional or expert competence and who has been
selected with reasonable care by or on behalf of the corporation.84
81
82
83
84
See Van Gorkom, 488 A.2d at 873.
Official Committee of Unsecured Creditors of Integrated Health Services, Inc. v. Elkins, 2004 WL 1949290 (Del. Ch.
Aug. 24, 2004) (Compensation Committee forgiveness of a loan to the CEO by written consent without any evidence of
director deliberation or reliance upon a compensation expert raised a Vice Chancellor’s “concern as to whether it acted
with knowing or deliberate indifference.”)
In Stone v. Ritter, 911 A.2d 362, 2006 WL 3169168 (Del. 2006), the Delaware Supreme Court held that “the
requirement to act in good faith is a subsidiary element, i.e., a condition, of the fundamental duty of loyalty.” See notes
59-74 and related text, supra.
DGCL § 141(e).
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Significantly, as discussed below, DGCL § 141(e) provides protection to directors only if they
acted in good faith.
d.
DGCL § 102(b)(7) Limitation on Director Liability.
The second statutory protection is DGCL § 102(b)(7), which allows a Delaware
corporation to provide limitations on (or partial elimination of) director liability in relation to the
duty of care, and reads as follows:
102 CONTENTS OF CERTIFICATE OF INCORPORATION.
***
(b)
In addition to the matters required to be set forth in the certificate of
incorporation by subsection (a) of this section, the certificate of incorporation may also
contain any or all of the following matters:
***
(7)
A provision eliminating or limiting the personal liability of a director to
the corporation or its stockholders for monetary damages for breach of fiduciary duty as a
director, provided that such provision shall not eliminate or limit the liability of a
director: (i) for any breach of the director’s duty of loyalty to the corporation or its
stockholders; (ii) for acts or omissions not in good faith or which involve intentional
misconduct or a knowing violation of law; (iii) under § 174 of this title; or (iv) for any
transaction from which the director derived an improper personal benefit. No such
provision shall eliminate or limit the liability of a director for any act or omission
occurring prior to the date when such provision becomes effective. All references in this
paragraph to a director shall also be deemed to refer (x) to a member of the governing
body of a corporation which is not authorized to issue capital stock, and (y) to such other
person or persons, if any, who, pursuant to a provision of the certificate of incorporation
in accordance with § 141(a) of this title, exercise or perform any of the powers or duties
otherwise conferred or imposed upon the board of directors by this title.85
85
The Texas analogue to DGCL § 102(b)(7) is TBOC § 7.001, which provides in relevant part:
(b) The certificate of formation or similar instrument of an organization to which this section applies
[generally, corporations] may provide that a governing person of the organization is not liable, or is
liable only to the extent provided by the certificate of formation or similar instrument, to the
organization or its owners or members for monetary damages for an act or omission by the person in the
person’s capacity as a governing person.
(c) Subsection (b) does not authorize the elimination or limitation of the liability of a governing person
to the extent the person is found liable under applicable law for:
(1) a breach of the person’s duty of loyalty, if any, to the organization or its owners or members;
(2) an act or omission not in good faith that:
(A) constitutes a breach of duty of the person to the organization; or
(B) involves intentional misconduct or a knowing violation of law;
(3) a transaction from which the person received an improper benefit, regardless of whether the
benefit resulted from an action taken within the scope of the person’s duties; or
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DGCL § 102(b)(7) in effect permits a corporation to include a provision in its certificate
of incorporation limiting or eliminating a director’s personal liability for monetary damages for
breaches of the duty of care.86 The liability of directors may not be so limited or eliminated,
however, in connection with breaches of the duty of loyalty, the failure to act in good faith,
intentional misconduct, knowing violations of law, obtaining improper personal benefits, or
paying dividends or approving stock repurchases in violation of DGCL § 174.87 Delaware courts
have routinely enforced DGCL § 102(b)(7) provisions and held that, pursuant to such provisions,
directors cannot be held monetarily liable for damages caused by alleged breaches of the
fiduciary duty of care.88
E.
Fiduciary Duties of Officers.
Under both Texas and Delaware law, a corporate officer owes fiduciary duties of care,
good faith and loyalty to the corporation and may be sued in a corporate derivative action just as
a director may be.89 To be held liable for a breach of fiduciary duty, “it will have to be
concluded for each of the alleged breaches that [an officer] had the discretionary authority in a
relevant functional area and the ability to cause or prevent a complained-of-action.”90 Derivative
claims against officers for failure to exercise due care in carrying out their responsibilities as
assigned by the board of directors are uncommon.
86
87
88
89
90
(4) an act or omission for which the liability of a governing person is expressly provided by an
applicable statute.
TMCLA art. 1302-7.06 provides substantially the same.
DGCL § 102(b)(7).
DGCL § 102(b)(7); see also Zirn v. VLI Corp., 621 A.2d 773, 783 (Del. 1993) (DGCL § 102(b)(7) provision in
corporation’s certificate did not shield directors from liability where disclosure claims involving breach of the duty of
loyalty were asserted).
A DGCL § 102(b)(7) provision does not operate to defeat the validity of a plaintiff’s claim on the merits, rather it
operates to defeat a plaintiff’s ability to recover monetary damages. Emerald Partners v. Berlin, 787 A.2d 85, 92 (Del.
2000). In determining when a DGCL § 102(b)(7) provision should be evaluated by the Court of Chancery to determine
whether it exculpates defendant directors, the Delaware Supreme Court recently distinguished between cases invoking
the business judgment presumption and those invoking entire fairness review (these standards of review are discussed
below). Id. at 92-3. The Court determined that if a stockholder complaint unambiguously asserts solely a claim for
breach of the duty of care, then the complaint may be dismissed by invocation of a DGCL § 102(b)(7) provision. Id. at
92. The Court held, however, that “when entire fairness is the applicable standard of judicial review, a determination
that the director defendants are exculpated from paying monetary damages can be made only after the basis for their
liability has been decided.” Id. at 94. In such a circumstance, defendant directors can avoid personal liability for
paying monetary damages only if they establish that their failure to withstand an entire fairness analysis was
exclusively attributable to a violation of the duty of care. Id. at 98.
Faour v. Faour, 789 S.W.2d 620,621 (Tex. App.—Texarkana 1990, writ denied); Zapata Corp. v. Maldonado, 430
A.2d 779 (Del. 1981); see Lifshutz v. Lifshutz, 199 S.W.3d 9, 18 (Tex. App.–San Antonio 2006) (“Corporate officers
owe fiduciary duties to the corporations they serve. [citation omitted]. A corporate fiduciary is under a duty not to
usurp corporate opportunities for personal gain, and equity will hold him accountable to the corporation for his profits
if he does so.”); Cotton v. Weatherford Bancshares, Inc., 187 S.W.3d 687, 698 (Tex. App.—Fort Worth 2006) (“While
corporate officers owe fiduciary duties to the corporation they serve, they do not generally owe fiduciary duties to
individual shareholders unless a contract or confidential relationship exists between them in addition to the corporate
relationship”).
Pereira v. Cogan, 294 B.R. 449, 511 (SDNY 2003), reversed on other grounds and remanded, Pereira v. Farace, 413
F.3d 330 (2nd Cir. 2005); see Fletcher Cyclopedia of the Law of Private Corporations, § 846 (2002) (“The Revised
Model Business Corporation Act provides that a non-director officer with discretionary authority is governed by the
same standards of conduct as a director.”).
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An individual is entitled to seek the best possible employment arrangements for himself
before he becomes a fiduciary, but once the individual becomes an officer or director, his ability
to pursue his individual self interest becomes restricted. In re The Walt Disney Co. Derivative
Litigation,91 which resulted from the failed marriage between Disney and its former President
Michael Ovitz, is instructive as to the duties of an officer.92 Ovitz was elected president of
Disney on October 1, 1995 prior to finalizing his employment contract, which was executed on
December 12, 1995, and he became a director in January 1996. Ovitz’s compensation package
was lucrative, including a $40 million termination payment for a no-fault separation. Ovitz’
tenure as an officer was mutually unsatisfying, and a year later he was terminated on a no-fault
basis. Derivative litigation ensued against Ovitz and the directors approving his employment and
separation arrangements.
The Delaware Supreme Court affirmed the Chancery Court rulings that (i) as to claims
based on Ovitz entering into his employment agreement with Disney, officers and directors
become fiduciaries only when they are officially installed and receive the formal investiture of
authority that accompanies such office or directorship, and before becoming a fiduciary, Ovitz
had the right to seek the best employment agreement possible for himself and (ii) as to claims
based on actions after he became an officer, (a) an officer may negotiate his or her own
employment agreement as long as the process involves negotiations performed in an adversarial
and arms-length manner, (b) Ovitz made the decision that a faithful fiduciary would make by
abstaining from attendance at a Compensation Committee meeting [of which he was an ex
officio member] where a substantial part of his own compensation was to be discussed and
decided upon, (c) Ovitz did not breach any fiduciary duties by executing and performing his
employment agreement after he became an officer since no material change was made in it from
the form negotiated and approved prior to his becoming an officer, and (d) Ovitz did not breach
any fiduciary duty in receiving no-fault termination payments because he played no part in the
determination that he would be terminated or that his termination would not be for cause.
A corporate officer is an agent of the corporation.93 If an officer commits a tort while
acting for the corporation, under the law of agency, the officer is liable personally for his
actions.94 The corporation may also be liable under respondeat superior.
91
92
93
906 A.2d 27 (Del. 2006).
See the discussion of the Disney case in notes 212-217 and related text, infra, in respect of director duties when
approving executive officer compensation.
Joseph Greenspon’s Sons Iron & Steel Co. v. Pecos Valley Gas Co., 156 A. 350 (Del. Ch. 193l); Hollaway v. Skinner,
898 S.W.2d 793, 795 (Tex. 1995). See Lyman Johnson, Having the Fiduciary Duty Talk: Model Advice for Corporate
Officers (and Other Senior Agents), 63 Bus. Law 147, 148-151 (Nov. 2007):
In thirty-four states there are both statutory and common law sources for officer fiduciary duties.
The remaining sixteen states [including Delaware and Texas] have only common law. The primary
common law source is the law of agency—officers being agents—and the recent Restatement (Third) of
Agency (“Restatement”) is the most authoritative and thorough source of agency law principles. * * *
[T]he Restatement states explicitly that an agent’s duty of loyalty is a “fiduciary duty.”
Interestingly, however, the Restatement describes the agent’s duties of care, competence, and diligence
as “performance” duties, deliberately avoiding the descriptor of “fiduciary,” while noting, however, that
other sources do refer to such duties as fiduciary in nature. Also, the Restatement establishes as the
standard applicable to the duties of care, competence, and diligence that level of conduct “normally
exercised by agents in similar circumstances.”
***
25
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F.
Derivative Actions.
The fiduciary duties of directors and officers are owed to the corporation they serve.
Thus, typically an action against a director or officer for breach of fiduciary duty would be
brought by or in the right of the corporation. Since the cause of action belongs to the
corporation, a disinterested board of directors would have the power to determine whether to
bring a breach of fiduciary duty claim for the corporation.95
Both Delaware96 and Texas97 law authorize an action brought in the right of the
corporation by a shareholder against directors or officers for breach of fiduciary duty.98 Such an
action is called a “derivative action.” In deference to the power of the Board, a shareholder
would ordinarily be expected to demand that the Board commence the action before
commencing a derivative action.99 An independent and disinterested Board could then decide
whether commencing the action would be in the best interest of the corporation and could decide
to have the action dismissed.100 Delaware and Texas differ in cases in which making such a
demand upon the Board is likely to have little or no effect, generally because a majority of the
Board lacks independence or is otherwise interested in the actions being disputed.
Delaware recognizes that a Board may not be disinterested and does not require demand
when it would be futile. Chancellor Chandler explained when demand will not be required in
Delaware in In re Tyson Foods, Inc. Consolidated Shareholder Litigation:101
The first hurdle facing any derivative complaint is Rule 23.1, which
requires that the complaint “allege with particularity the efforts, if any, made by
the plaintiff to obtain the action the plaintiff desires from the directors . . . and the
reasons for the plaintiff’s failure to obtain the action or for not making the effort.”
Rule 23.1 stands for the proposition in Delaware corporate law that the business
and affairs of a corporation, absent exceptional circumstances, are to be managed
by its board of directors. To this end, Rule 23.1 requires that a plaintiff who
asserts that demand would be futile must “comply with stringent requirements of
factual particularity that differ substantially from the permissive notice pleadings”
94
95
96
97
98
99
100
101
Finally, the Restatement states that a “general or broad” advance release of an agent from the
agent’s “general fiduciary obligation to the principal [i.e., the duty of loyalty] is not likely to be
enforceable.” As to the duties of care, competence, and diligence, however, the Restatement states that a
“contract may, in appropriate circumstances, raise or lower the standard” applicable to those duties and
that such duties can be “contractually shaped,” but it does not indicate whether they can be eliminated
altogether.
Dana M. Muir & Cindy A. Schipani, The Intersection of State Corporation Law and Employee Compensation
Programs: Is it Curtains for Veil Piercing? 1996 U. ILL. L. REV. 1059, 1078-1079 (1996).
See Wingate v. Hajdik, 795 S.W.2d 717, 719 (Tex. 1990) (“Ordinarily, the cause of action for injury to the property of a
corporation, or the impairment or destruction of its business, is vested in the corporation, as distinguished from its
stockholders . . . .”); Pace v. Jordan, 999 S.W.2d 615, 622 (Tex. App. – Houston [1st Dist.] 1999, pet. denied) (noting
that “[a] corporation’s directors, not its shareholders, have the right to control litigation of corporate causes of action”).
Del. Court of Chancery Rule 23.1.
TBCA art. 5.14 and TBOC §§ 21.551-21.563.
TBCA art. 5.14 and TBOC §§ 21.551-21.563.
Del. Court of Chancery Rule 23.1; TBCA art. 5.14C; TBOC § 21.553.
TBCA art. 5.14F and TBOC § 21.558; see discussion of In re Oracle Corp. Derivative Litigation in note 138, infra.
919 A.2d 563, 2007 WL 416132 (Del.Ch. Feb. 6, 2007).
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normally governed by Rule 8(a). Vague or conclusory allegations do not suffice
to upset the presumption of a director’s capacity to consider demand. As
famously explained in Aronson v. Lewis, plaintiffs may establish that demand was
futile by showing that there is a reason to doubt either (a) the distinterestedness
and independence of a majority of the board upon whom demand would be made,
or (b) the possibility that the transaction could have been an exercise of business
judgment.
There are two ways that a plaintiff can show that a director is unable to act
objectively with respect to a pre-suit demand. Most obviously, a plaintiff can
assert facts that demonstrate that a given director is personally interested in the
outcome of litigation, in that the director will personally benefit or suffer as a
result of the lawsuit in a manner that differs from shareholders generally. A
plaintiff may also challenge a director’s independence by alleging facts
illustrating that a given director is dominated through a “close personal or familial
relationship or through force of will,” or is so beholden to an interested director
that his or her “discretion would be sterilized.” Plaintiffs must show that the
beholden director receives a benefit “upon which the director is so dependent or is
of such subjective material importance that its threatened loss might create a
reason to question whether the director is able to consider the corporate merits of
the challenged transaction objectively.”
The Chancellor further elaborated on demand futility in Ryan v. Gifford,102 as follows:
Defendants state that plaintiff has failed to make demand or prove demand
futility. That is, defendants contend that the complaint lacks particularized facts
that either establish that a majority of directors face a “substantial likelihood” of
personal liability for the wrongdoing alleged in the complaint or render a majority
of the board incapable of acting in an independent and disinterested fashion
regarding demand.
When a shareholder seeks to maintain a derivative action on behalf of a
corporation, Delaware law requires that shareholder to first make demand on that
corporation’s board of directors, giving the board the opportunity to examine the
alleged grievance and related facts and to determine whether pursuing the action
is in the best interest of the corporation. This demand requirement works “to curb
a myriad of individual shareholders from bringing potentially frivolous lawsuits
on behalf of the corporation, which may tie up the corporation’s governors in
constant litigation and diminish the board’s authority to govern the affairs of the
corporation.”
This Court has recognized, however, that in some cases demand would
prove futile. Where the board’s actions cause the shareholders’ complaint, “a
question is rightfully raised over whether the board will pursue these claims with
100% allegiance to the corporation, since doing so may require that the board sue
102
918 A.2d 341 (Del. Ch. Feb. 6, 2007).
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itself on behalf of the corporation.” Thus, in an effort to balance the interest of
preventing “strike suits motivated by the hope of creating settlement leverage
through the prospect of expensive and time-consuming litigation discovery [with
the interest of encouraging] suits reflecting a reasonable apprehension of
actionable director malfeasance that the sitting board cannot be expected to
objectively pursue on the corporation’s behalf,” Delaware law recognizes two
instances where a plaintiff is excused from making demand. Failure to make
demand may be excused if a plaintiff can raise a reason to doubt that: (1) a
majority of the board is disinterested or independent or (2) the challenged acts
were the product of the board’s valid exercise of business judgment.
The analysis differs, however, where the challenged decision is not a
decision of the board in place at the time the complaint is filed. * * *
Accordingly, where the challenged transaction was not a decision of the board
upon which plaintiff must seek demand, plaintiff must “create a reasonable doubt
that, as of the time the complaint is filed, the board of directors could have
properly exercised its independent and disinterested business judgment in
responding to a demand.”
* * * Where at least one half or more of the board in place at the time the
complaint was filed approved the underlying challenged transactions, which
approval may be imputed to the entire board for purposes of proving demand
futility, [demand may be excused].
In Delaware a derivative plaintiff must have been a stockholder continuously from the
time of the transaction in question through the completion of the lawsuit.103 Stockholders who
obtained their shares in a merger lack derivative standing to challenge pre-merger actions.104
In Texas a shareholder bringing a derivative suit must file a written demand in order to
maintain the suit, and no showing of futility can excuse this requirement. Additionally, a 90-day
waiting period is required from the delivery of the demand notice until the commencement of a
suit.105 This waiting period can only be avoided if the shareholder is earlier notified that the
103
104
105
Id.; 8 Del. Code § 327.
Cf. Louisiana Municipal Police Employees’ Retirement Sys. v. Crawford, Civil Action No. 2635-N (Del. Ch. February
13, 2007) and Express Scripts, Inc. v. Crawford, Civil Action No. 2663-N (Del. Ch. February 13, 2007), in which the
Chancellor delayed a stockholders meeting to vote on the proposed Caremark Rx/CVS merger from February 20, 2007
to March 9, 2007 to allow disclosures that (i) Caremark had three times discussed a possible transaction with Express
Scripts even though after its agreement with CVS, Caremark was arguing that antitrust concerns even precluded talking
to this higher bidder, and (ii) any merger of Caremark could cause other plaintiffs to lose standing to sue Caremark Rx
directors for breach of fiduciary duty in respect of alleged options backdating; but cf. In re CheckFree Corp., No. 3193CC, 2007 WL 3262188 (Del. Ch. Nov. 1, 2007) in which Chancellor Chandler denied a claim that management failed
to disclose the effect of a merger on a pending derivative action and that the merger would likely extinguish the claim
and free one of the directors from liability, holding that “directors need not [give legal advice and] tell shareholders that
a merger will extinguish pending derivative claims.” Though such information may be helpful in an abstract sense, the
Court found it unlikely the disclosure would “alter the total mix of information available.”
TBCA art. 5.14(C)(2); TBOC § 21.553(a).
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Board has rejected their demand, or if “irreparable harm to the corporation is being suffered or
would result by waiting for the expiration of the 90-day period.”106
The written demand must meet a stringent set of particularity requirements in order to
satisfy the Texas Corporate Statutes.107 Though much of the analysis done by the courts to
evaluate potential “irreparable harm” may be similar to the analysis required for demand futility
claims in Delaware, the fact that the Texas Corporate Statutes focus on the harm to the
corporation, rather than the apparent futility of demand, presents a slightly different set of issues
than are normally addressed in cases involving Delaware corporations.
Another potential difference between Delaware and Texas law is with respect to the
effect of a merger in which the corporation is not the surviving entity on a derivative action.
Under Delaware law, in the absence of fraud, “the effect of a merger . . . is normally to deprive a
shareholder of the merged corporation of standing to maintain a derivative action,”108 but the
result may not be the same under Texas law. Like Delaware, the Federal Rules of Civil
Procedure and Texas authority under prior derivative action provisions in the TBCA require that
the claimant in a derivative case remain a shareholder throughout the course of the derivative
claim,109 which requirement would not be satisfied where a derivative plaintiff’s shares in the
corporation are converted into the merger consideration. A Texas court has not ruled on the
106
107
108
109
TBCA art. 5.14(C)(2); TBOC § 21.553(b).
Marron v. Ream, Civil Action No. H-06-1394, 2006 U.S. Dist. LEXIS 72831, at *18–20 (S.D. Tex. May 8, 2006);
Equitec-Cole Roesler v. McClanahan, 251 F. Supp. 2d 1347, 1350 (S.D. Tex. 2003).
Lewis v. Anderson, 477 A.2d 1040, 1047–49 (Del. 1984); see Elloway v. Pate, 238 S.W.3d 882, 900 (Tex.App.—
Houston [14th Dist.] 2007) in which a Texas court applying Delaware law held that a merger eliminated standing to
bring a derivative action, but not a direct action, and explained: “A derivative claim is brought by a stockholder, on
behalf of the corporation, to recover harm done to the corporation. Tooley v. Donaldson, Lufkin & Jenrette, 845 A.2d
1031, 1036 (Del. 2004). A stockholder’s direct claim must be independent of any alleged injury to the corporation. Id.
at 1039. If the stockholder’s claim is derivative, the stockholder loses standing to pursue his claim upon
accomplishment of the merger. Parnes v. Bally Entm’t Corp., 722 A.2d 1243, 1244-45 (Del. 1999). A stockholder
who directly attacks the fairness or validity of a merger alleges an injury to the stockholders, not the corporation, and
may pursue such claim even after the merger at issue has been consummated. Id. at 1245. To state a direct claim with
respect to a merger, a stockholder must challenge the validity of the merger itself, usually by charging the directors
with breaches of fiduciary duty in unfair dealing and/or unfair price. Id. at 1245.” Cf. Pate v. Elloway, No. 01-0300187-CV, 2003 WL 22682422 (Tex.App.—Houston [1st Dist.] Nov. 13, 2003, pet. denied).
Fed. R. Civ. P. 23.1 (2007); Schilling v. Belcher, 582 F.2d 995, 999 (5th Cir. 1978) (“the [stock] ownership
requirement continues throughout the life of the suit. . . .”); Romero v. US Unwired, Inc., No. 04-2312, 2006 WL
2366342, at *5 (E.D. La. Aug. 11, 2006) (slip op.) (holding that merger divested shareholder plaintiff of standing to
pursue derivative claim under Fed. R. Civ. P. 23.1 and dismissing suit); Zauber v. Murray Sav. Ass’n, 591 S.W.2d 932,
937-938 (Tex. Civ. App. 1979) (“The requirement in article [TBCA] 5.14(B) [as it existed in 1979] that in order to
bring a derivative suit a plaintiff must have been a shareholder at the time of the wrongful transaction, is only a
minimum requirement. The federal rule governing derivative suits, which contains similar requirements to article
5.14(B), has been construed to include a further requirement that shareholder status be maintained throughout the suit.
[citations omitted] The reasoning behind allowing a shareholder to maintain a suit in the name of the corporation when
those in control wrongfully refuse to maintain it is that a shareholder has a proprietary interest in the corporation.
Therefore, when a shareholder sues, he is protecting his own interests a well as those of the corporation. If a
shareholder voluntarily disposes of his shares after instituting a derivative action, he necessarily destroys the technical
foundation of his right to maintain the action. [citation omitted] If, on the other hand, a shareholder’s status is
involuntarily destroyed, a court of equity must determine whether the status was destroyed without a valid business
purpose; for example, was the action taken merely to defeat the plaintiff’s standing to maintain the suit? * * * If no
valid business purpose exists, a court of equity will consider the destruction of a stockholder’s status a nullity and allow
him to proceed with the suit in the name of the corporation. Therefore, on remand of this suit, a finding that appellant
has failed to maintain his status as shareholder is dependent upon findings that the disposition of the stock was
voluntary or, though involuntary, that the corporation’s termination proceeding was instituted to accomplish a valid
business purpose, rather than to dispose of the derivative suit by a reverse stock split.”).
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merger survival issue under the derivative provisions in the current Texas Corporate Statutes.110
Whereas Delaware law explicitly allows for direct suit in such cases, Gearhart held that under
Texas law fiduciary claims in connection with a merger are the right of the corporation itself, not
individual shareholders.111
G.
Effect of Sarbanes-Oxley Act of 2002 on Common Law Fiduciary Duties.
1.
Overview.
Responding to problems in corporate governance, SOX and related changes to SEC rules
and stock exchange listing requirements112 have implemented a series of reforms that require all
public companies113 to implement or refrain from specified actions,114 some of which are
expressly permitted by state corporate laws, subject to general fiduciary principles. Several
110
111
112
113
114
TBCA art. 5.03(M) provides that for the purposes of TBCA art. 5.03: “To the extent a shareholder of a corporation has
standing to institute or maintain derivative litigation on or behalf of the corporation immediately before a merger,
nothing in this article may be construed to limit or extinguish the shareholder’s standing.” The impact of this provision
has not been directly tested in a Texas court, but at least one federal court interpreting Texas law has suggested that
under TBCA art. 5.03(M) a shareholder who could have properly brought a derivative suit prior to a merger will
maintain that right, even after a merger has rendered the corporation in question nonexistent. See Marron v. Ream,
Civil Action No. H-06-1394, 2006 U.S. Dist. LEXIS 72831, at *23 (S.D. Tex. May 8, 2006). Substantially the same
language is included in TBOC § 21.552(b).
Gearhart Indus., Inc. v. Smith Int’l. Inc., 741 F.2d 707,721 (5th Cir. 1984).
On November 4, 2003, the SEC issued Release No. 34-48745, titled “Self-Regulatory Organizations; New York Stock
Exchange, Inc. and National Association of Securities Dealers, Inc.; Order Approving Proposed Rule Changes
[citations omitted],” which can be found at http://www.sec.gov/rules/sro/34-48745.htm, pursuant to which the SEC
approved the rule changes proposed by the NYSE and NASD to comply with SOX. These rule changes are now
effective for all NYSE and NASDAQ listed companies. Any references to the rules in the NYSE Listed Company
Manual (the “NYSE Rules”) or the marketplace rules in the NASD Manual (the “NASD Rules”) are references to the
rules as approved by the SEC on November 4, 2003.
The SOX is generally applicable to all companies required to file reports with the SEC under the 1934 Act (“reporting
companies”) or that have a registration statement on file with the SEC under the 1933 Act, in each case regardless of
size (collectively, “public companies” or “issuers”). Some of the SOX provisions apply only to companies listed on a
national securities exchange (“listed companies”), such as the New York Stock Exchange (“NYSE”), the American
Stock Exchange (“AMEX”) or the NASDAQ Stock Market (“NASDAQ”) (the national securities exchanges and
NASDAQ are referred to collectively as “SROs”), but not to companies traded on the NASD OTC Bulletin Board or
quoted in the Pink Sheets or the Yellow Sheets. Small business issuers that file reports on Form 10-QSB and Form 10KSB are subject to SOX generally in the same ways as larger companies although some specifics vary. SOX and the
SEC’s rules thereunder are applicable in many, but not all, respects to (i) investment companies registered under the
Investment Company Act of 1940 (the “1940 Act”) and (ii) public companies domiciled outside of the U.S. (“foreign
companies”), although many of the SEC rules promulgated under SOX’s directives provide limited relief from some
SOX provisions for the “foreign private issuer,” which is defined in 1933 Act Rule 405 and 1934 Act Rule 3b-4(c) as a
private corporation or other organization incorporated outside of the U.S., as long as:
●
More than 50% of the issuer’s outstanding voting securities are not directly or indirectly held
of record by U.S. residents;
●
The majority of the executive officers or directors are not U.S. citizens or residents;
●
More than 50% of the issuer’s assets are not located in the U.S.; and;
●
The issuer’s business is not administered principally in the U.S.
See Appendix A; Byron F. Egan, The Sarbanes-Oxley Act and Its Expanding Reach, 40 Texas Journal of Business Law
305 (Winter 2005), which can be found at http://www.jw.com/site/jsp/publicationinfo.jsp?id=505; Byron F. Egan,
Communicating with Auditors After the Sarbanes-Oxley Act, 41 Texas Journal of Business Law 131 (Fall 2005); and
Byron F. Egan, Communications with Accountants After the Sarbanes-Oxley Act (including Attorney Letters to
Auditors re Loss Contingencies, Attorney Duties under SOX §§ 303 and 307, Options Backdating) (Oct. 24, 2006),
which can be found at http://www.jw.com/site/jsp/publicationinfo.jsp?id=624.
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examples of this interaction of state law with SOX or new SEC or stock exchange requirements
are discussed below.
2.
Shareholder Causes of Action.
SOX does not create new causes of action for shareholders, with certain limited
exceptions, and leaves enforcement of its proscriptions to the SEC or federal criminal
authorities.115 The corporate plaintiffs’ bar, however, can be expected to be creative and
aggressive in asserting that the new standards of corporate governance should be carried over
into state law fiduciary duties, perhaps by asserting that violations of SOX constitute violations
of fiduciary duties of obedience or supervision.116
3.
Director Independence.
a.
Power to Independent Directors.
(1)
General. The SEC rules under SOX and related stock exchange listing
requirements are shifting the power to govern public companies to outside directors.
Collectively, they will generally require that listed companies have:
115
116
117
118
119
•
A board of directors, a majority of whom are independent;117
•
An audit committee118 composed entirely of independent directors;119
“Except in the case of recovery of profits from prohibited sales during a blackout period and suits by whistleblowers,
the Sarbanes-Oxley Act does not expressly create new private rights of action for civil liability for violations of the Act.
The Sarbanes-Oxley Act, however, potentially affects existing private rights of action under the Exchange Act by: (1)
lengthening the general statute of limitations applicable to private securities fraud actions to the earlier of two years
after discovery of the facts constituting the violation or five years after the violation; and (2) expanding reporting and
disclosure requirements that could potentially expand the range of actions that can be alleged to give rise to private
suits under Section 10(b) and Section 18 of the Exchange Act and SEC Rule 10b-5.” Patricia A. Vlahakis et al.,
Understanding the Sarbanes-Oxley Act of 2002, CORP. GOVERNANCE REFORM, Sept.-Oct. 2002, at 16.
See William B. Chandler III and Leo E. Strine Jr., The New Federalism of the American Corporate Governance
System: Preliminary Reflections of Two Residents of One Small State (February 26, 2002), which can be found at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=367720, at 43-48.
See NYSE Rules 303A.01 and 303A.02; NASD Rules 4350(c)(1) and 4200(a)(15).
1934 Act § 3(a)(58) added by SOX § 2(a)(3) provides:
(58)
Audit Committee. The term “audit committee” means –
(A) A committee (or equivalent body) established by and amongst the board of directors of an issuer for
the purpose of overseeing the accounting and financial reporting processes of the issuer and audits
of the financial statements of the issuer; and
(B) If no such committee exists with respect to an issuer, the entire board of directors of the issuer.
On April 9, 2003, the SEC issued Release No. 33-8220 (the “SOX §301 Release”) adopting, effective April 25, 2003,
1934 Act Rule 10A-3, titled “Standards Relating to Listed Company Audit Committees” (the “SOX §301 Rule”),
which can be found at http://www.sec.gov/rules/final/33-8220.htm, to implement SOX §301. Under the SOX §301
Rule, each SRO must adopt rules conditioning the listing of any securities of an issuer upon the issuer being in
compliance with the standards specified in SOX §301, which may be summarized as follows:
● Oversight. The audit committee must have direct responsibility for the appointment, compensation, and oversight
of the work (including the resolution of disagreements between management and the auditors regarding financial
reporting) of any registered public accounting firm employed to perform audit services, and the auditors must
report directly to the audit committee.
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•
A nominating/corporate governance committee composed entirely of independent
directors;120 and
•
A compensation committee composed entirely of independent directors.121
These independent directors will be expected to actively participate in the specified
activities of the board of directors and the committees on which they serve.
State law authorizes boards of directors to delegate authority to committees of directors.
Texas and Delaware law both provide that boards of directors may delegate authority to
committees of the board subject to limitations on delegation for fundamental corporate
transactions.122 Among the matters that a committee of a board of directors will not have the
authority to approve are (i) charter amendments, except to the extent such amendments are the
result of the issuance of a series of stock permitted to be approved by a board of directors, (ii) a
plan of merger or similar transaction, (iii) the sale of all or substantially all of the assets of the
Independence. The audit committee members must be independent directors, which means that each member may
not, other than as compensation for service on the board of directors or any of its committees: (i) accept any
consulting, advisory or other compensation, directly or indirectly, from the issuer or (ii) be an officer or other
affiliate of the issuer.
● Procedures to Receive Complaints. The audit committee is responsible for establishing procedures for the receipt,
retention and treatment of complaints regarding accounting, internal accounting controls or auditing matters, and
the confidential, anonymous submission by employees of the issuer (“whistleblowers”) of concerns regarding
questionable accounting or auditing matters.
● Funding and Authority. The audit committee must have the authority to hire independent counsel and other
advisers to carry out its duties, and the issuer must provide for funding, as the audit committee may determine, for
payment of compensation of the issuer’s auditor and of any advisors that the audit committee engages.
SROs may adopt additional listing standards regarding audit committees as long as they are consistent with SOX and
the SOX §301 Rule. The NYSE and NASD have adopted such rules, which are discussed below. See NYSE Rules
303A.06 and 303A.07 and NASD Rule 4350(d).
See NYSE Rule 303A.04; NASD Rule 4350(c)(4).
See NYSE Rule 303A.05; NASD Rule 4350(c)(3). The compensation committee typically is composed of independent
directors and focuses on executive compensation and administration of stock options and other incentive plans. While
the duties of the compensation committee will vary from company to company, the ALI’s Principles of Corporate
Governance § 3A.05 (Supp 2002) recommend that the compensation committee should:
(1) Review and recommend to the board, or determine, the annual salary, bonus, stock options, and other benefits,
direct and indirect, of the senior executives.
(2) Review new executive compensation programs; review on a periodic basis the operation of the corporation’s
executive compensation programs to determine whether they are properly coordinated; establish and periodically
review policies for the administration of executive compensation programs; and take steps to modify any
executive compensation programs that yield payments and benefits that are not reasonably related to executive
performance.
(3) Establish and periodically review policies in the area of management perquisites.
Under SEC Rule 16b-3 under the 1934 Act, the grant and exercise of employee stock options, and the making of
stock awards, are generally exempt from the short-swing profit recovery provisions of § 16(b) under the 1934 Act
if approved by a committee of independent directors. Further, under Section 162(m) of the Internal Revenue Code
of 1980, as amended, corporations required to be registered under the 1934 Act are not able to deduct
compensation to specified individuals in excess of $1,000,000 per year, except in the case of performance based
compensation arrangements approved by the shareholders and administered by a compensation committee
consisting of two or more “outside directors” as defined. Treas. Reg. § 1.162-27 (2002).
TBOC § 21.416; TBCA art. 2.36; DGCL § 141(c). These restrictions only apply to Delaware corporations that
incorporated prior to July 1, 1996, and did not elect by board resolution to be governed by DGCL § 141(c)(2). If a
Delaware corporation is incorporated after that date or elects to be governed by DGCL § 141(c)(2), then it may
authorize a board committee to declare dividends or authorize the issuance of stock of the corporation.
●
120
121
122
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corporation outside the ordinary course of its business, (iv) a voluntary dissolution of the
corporation and (v) amending bylaws or creating new bylaws of the corporation.123 In addition,
under Texas law, a committee of a board of directors may not fill any vacancy on the board of
directors, remove any officer, fix the compensation of a member of the committee or amend or
repeal a resolution approved by the whole board to the extent that such resolution by its terms is
not so amendable or repealable.124 Further, under both Texas and Delaware law, no committee
of a board of directors has the authority to authorize a distribution (a dividend in the case of
Delaware law) or authorize the issuance of stock of a corporation unless that authority is set forth
in the charter or bylaws of the corporation.125 Alternative members may also be appointed to
committees under both states’ laws.126
(2)
NYSE. NYSE Rule 303A.01 requires the board of directors of each NYSE listed
company to consist of a majority of independent directors.
(a)
NYSE Base Line Test. Pursuant to NYSE Rule 303A.02, no director
qualifies as “independent” unless the board affirmatively determines that the director has no
material relationship with the company (either directly or as a partner, shareholder or officer of
an organization that has a relationship with the company). The company is required to disclose
the basis for such determination in its annual proxy statement or, if the company does not file an
annual proxy statement, in the company’s annual report on Form 10-K filed with the SEC. In
complying with this requirement, the company’s board is permitted to adopt and disclose
standards to assist it in making determinations of independence, disclose those standards, and
then make the general statement that the independent directors meet those standards.
(b)
NYSE Per Se Independence Disqualifications. In addition to the general
requirement discussed above, NYSE Rule 303A.02 considers a number of relationships to be an
absolute bar on a director being independent as follows:
First, a director who is an employee, or whose immediate family member is an
executive officer, of the company would not be independent until three years after
the end of such employment (employment as an interim Chairman or CEO will
not disqualify a director from being considered independent following that
employment).
Second, a director who has received, or whose immediate family member has
received, more than $100,000 in any twelve-month period within the last three
years in direct compensation from the NYSE listed company, except for certain
payments, would not be independent.
Third, a director who is, or who has an immediate family member who is, a
current partner of a firm that is the NYSE listed company’s internal or external
auditor; a director who is a current employee of such a firm; a director who has an
123
124
125
126
TBOC § 21.416; TBCA art. 2.36; DGCL § 141(c).
TBOC § 21.416; TBCA art. 2.36B.
TBOC § 21.416(d); TBCA art. 2.36C; DGCL § 141(c)(1). In Texas such authorization may alternatively appear in the
resolution designating the committee. TBOC § 21.416(d); TBCA art. 2.36C.
TBOC § 21.416(a); TBCA art. 2.36A; DGCL § 141(c)(1).
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immediate family member who is a current employee of such a firm and who
participates in the firm’s audit, assurance or tax compliance (but not tax planning)
practice; or a director who was, or who has an immediate family member who
was, within the last three years (but is no longer) a partner or employee of such a
firm and personally worked on the NYSE listed company’s audit within that time.
Fourth, a director who is employed, or whose immediate family member is
employed, as an executive officer of another company where any of the NYSE
listed company’s present executives served on that company’s compensation
committee at the same time can not be considered independent until three years
after the end of such service or the employment relationship.
Fifth, a director who is a current employee, or whose immediate family member is
a current executive officer, of a company that has made payments to, or received
payments from, the NYSE listed company for property or services in an amount
which, in any of the last three fiscal years, exceeds the greater of $1 million, or
2% of such other company’s consolidated gross revenues.
Charitable
organizations are not considered “companies” for purposes of the exclusion from
independence described in the previous sentence, provided that the NYSE listed
company discloses in its annual proxy statement, or if the NYSE listed company
does not file an annual proxy statement, in its annual report on Form 10-K filed
with the SEC, any charitable contributions made by the NYSE listed company to
any charitable organization in which a director serves as an executive officer if,
within the preceding three years, such contributions in any single year exceeded
the greater of $1 million or 2% of the organization’s consolidated gross revenues.
(3)
NASDAQ. NASD Rule 4350(c)(1) requires a majority of the directors of a
NASDAQ-listed company to be “independent directors,” as defined in NASD Rule 4200.127
(a)
NASDAQ Base Line Test. NASD Rule 4350(c)(1) requires each
NASDAQ listed company to disclose in its annual proxy (or, if the issuer does not file a proxy,
in its Form 10-K or 20-F) those directors that the board has determined to be independent as
defined in NASD Rule 4200.128
(b)
NASDAQ Per Se Independence Disqualifications.
NASD Rule
4200(a)(15) specifies certain relationships that would preclude a board finding of independence
as follows:
127
128
NASD Rule 4350, which governs qualitative listing requirements for NASDAQ National Market and NASDAQ
SmallCap Market issuers (other than limited partnerships), must be read in tandem with NASD Rule 4200, which
provides definitions for the applicable defined terms.
If a NASDAQ listed company fails to comply with the requirement that a majority of its board of directors be
independent due to one vacancy, or one director ceases to be independent due to circumstances beyond a company’s
reasonable control, NASD Rule 4350(c)(1) requires the issuer to regain compliance with the requirement by the earlier
of its next annual shareholders meeting or one year from the occurrence of the event that caused the compliance failure.
Any issuer relying on this provision must provide notice to NASDAQ immediately upon learning of the event or
circumstance that caused the non-compliance.
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First, a director who is, or at anytime during the past three years was, employed
by the NASDAQ listed company or by any parent or subsidiary of the company
(the “NASDAQ Employee Provision”).
Second, a director who accepted or has a family member who accepted any
payments from the NASDAQ listed company, or any parent or subsidiary of the
company, in excess of $60,000 during any period of twelve consecutive months
within the three years preceding the determination of independence other than
certain permitted payments (the “NASDAQ Payments Provision”). NASDAQ
states in the interpretive material to the NASD Rules (the “NASDAQ Interpretive
Material”) that this provision is generally intended to capture situations where a
payment is made directly to, or for the benefit of, the director or a family member
of the director. For example, consulting or personal service contracts with a
director or family member of the director or political contributions to the
campaign of a director or a family member of the director prohibit independence.
Third, a director who is a family member of an individual who is, or at any time
during the past three years was, employed by the company or by any parent or
subsidiary of the company as an executive officer (the “NASDAQ Family of
Executive Officer Provision”).
Fourth, a director who is, or has a family member who is, a partner in, or a
controlling shareholder or an executive officer of, any organization to which the
company made, or from which the company received, payments for property or
services in the current or any of the past three fiscal years that exceed 5% of the
recipient’s consolidated gross revenues for that year, or $200,000, whichever is
more, other than certain permitted payments (the “NASDAQ Business
Relationship Provision”). The NASDAQ Interpretive Material states that this
provision is generally intended to capture payments to an entity with which the
director or family member of the director is affiliated by serving as a partner
(other than a limited partner), controlling shareholder or executive officer of such
entity. Under exceptional circumstances, such as where a director has direct,
significant business holdings, the NASDAQ Interpretive Material states that it
may be appropriate to apply the NASDAQ Business Relationship Provision in
lieu of the NASDAQ Payments Provision described above, and that issuers should
contact NASDAQ if they wish to apply the rule in this manner. The NASDAQ
Interpretive Material further notes that the NASDAQ Business Relationship
Provision is broader than the rules for audit committee member independence set
forth in 1934 Act Rule 10A-3(e)(8).
The NASDAQ Interpretive Material further states that under the NASDAQ
Business Relationship Provision, a director who is, or who has a family member
who is, an executive officer of a charitable organization may not be considered
independent if the company makes payment to the charity in excess of the greater
of 5% of the charity’s revenues or $200,000. The NASDAQ Interpretive Material
also discusses the treatment of payments from the issuer to a law firm in
determining whether a director who is a lawyer may be considered independent.
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The NASDAQ Interpretive Material notes that any partner in a law firm that
receives payments from the issuer is ineligible to serve on that issuer’s audit
committee.
Fifth, a director who is, or has a family member who is, employed as an executive
officer of another entity where at any time during the past three years any of the
executive officers of the NASDAQ listed company serves on the compensation
committee of such other entity (“NASDAQ Interlocking Directorate Provision”).
Sixth, a director who is, or has a family member who is, a current partner of the
company’s outside auditor, or was a partner or employee of the company’s
outside auditor, and worked on the company’s audit, at any time, during the past
three years (“NASDAQ Auditor Relationship Provision”).
Seventh, in the case of an investment company, a director who is an “interested
person” of the company as defined in section 2(a)(19) of the Investment Company
Act, other than in his or her capacity as a member of the board of directors or any
board committee.
With respect to the look-back periods referenced in the NASDAQ Employee Provision,
the NASDAQ Family of Executive Officer Provision, the NASDAQ Interlocking Directorate
Provision, and the NASDAQ Auditor Relationship Provision, “any time” during any of the past
three years should be considered. The NASDAQ Interpretive Material states that these three
year look-back periods commence on the date the relationship ceases. As an example, the
NASDAQ Interpretive Material states that a director employed by the NASDAQ listed company
would not be independent until three years after such employment terminates. The NASDAQ
Interpretive Material states that the reference to a “parent or subsidiary” in the definition of
independence is intended to cover entities the issuer controls and consolidates with the issuer’s
financial statements as filed with the SEC (but not if the issuer reflects such entity solely as an
investment in its financial statements). The NASDAQ Interpretive Material also states that the
reference to “executive officer” has the same meaning as the definition in Rule 16a-1(f) under the
1934 Act.
b.
Audit Committee Member Independence.
(1)
SOX. To be “independent” and thus eligible to serve on an issuer’s audit
committee under the SOX §301 Rule, (i) audit committee members may not, directly or
indirectly, accept any consulting, advisory or other compensatory fee from the issuer or a
subsidiary of the issuer, other than in the member’s capacity as a member of the board of
directors and any board committee (this prohibition would preclude payments to a member as an
officer or employee, as well as other compensatory payments; indirect acceptance of
compensatory payments includes payments to spouses, minor children or stepchildren or children
or stepchildren sharing a home with the member, as well as payments accepted by an entity in
which an audit committee member is a general partner, managing member, executive officer or
occupies a similar position and which provides accounting, consulting, legal, investment
banking, financial or other advisory services or any similar services to the issuer or any
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subsidiary; receipt of fixed retirement plan or deferred compensation is not prohibited)129 and (ii)
a member of the audit committee of an issuer may not be an “affiliated person” of the issuer or
any subsidiary of the issuer apart from his or her capacity as a member of the board and any
board committee (subject to the safe harbor described below).130
Since it is difficult to determine whether someone controls the issuer, the SOX §301 Rule
creates a safe harbor regarding whether someone is an “affiliated person” for purposes of
meeting the audit committee independence requirement. Under the safe harbor, a person who is
not an executive officer, director or 10% shareholder of the issuer would be deemed not to
control the issuer. A person who is ineligible to rely on the safe harbor, but believes that he or
she does not control an issuer, still could rely on a facts and circumstances analysis. This test is
similar to the test used for determining insider status under §16 of the 1934 Act.
The SEC has authority to exempt from the independence requirements particular
relationships with respect to audit committee members, if appropriate in light of the
circumstances. Because companies coming to market for the first time may face particular
difficulty in recruiting members that meet the proposed independence requirements, the SOX
§301 Rule provides an exception for non-investment company issuers that requires only one
fully independent member at the time of the effectiveness of an issuer’s initial registration
statement under the 1933 Act or the 1934 Act, a majority of independent members within 90
days and a fully independent audit committee within one year.
For companies that operate through subsidiaries, the composition of the boards of the
parent company and subsidiaries are sometimes similar given the control structure between the
parent and the subsidiaries. If an audit committee member of the parent is otherwise
independent, merely serving on the board of a controlled subsidiary should not adversely affect
the board member’s independence, assuming that the board member also would be considered
independent of the subsidiary except for the member’s seat on the parent’s board. Therefore,
SOX §301 Rule exempts from the “affiliated person” requirement a committee member that sits
on the board of directors of both a parent and a direct or indirect subsidiary or other affiliate, if
the committee member otherwise meets the independence requirements for both the parent and
the subsidiary or affiliate, including the receipt of only ordinary-course compensation for serving
as a member of the board of directors, audit committee or any other board committee of the
parent, subsidiary or affiliate. Any issuer taking advantage of any of the exceptions described
above would have to disclose that fact.
(2)
NYSE.
(i)
Audit Committee Composition. NYSE Rules 303A.06 and 303A.07
require each NYSE listed company to have, at a minimum, a three person audit committee
129
130
The SOX §301 Rule restricts only current relationships and does not extend to a “look back” period before appointment
to the audit committee, although SRO rules may do so.
The terms “affiliate” and “affiliated person” are defined consistent with other definitions of those terms under the
securities laws, such as in 1934 Act Rule 12b-2 and 1933 Act Rule 144, with an additional safe harbor. In the SOX
§301 Release, the SEC clarified that an executive officer, general partner and managing member of an affiliate would
be deemed to be an affiliate, but outside directors, limited partners and others with no policy making function would
not be deemed affiliates. Similarly, a member of the audit committee of an issuer that is an investment company could
not be an “interested person” of the investment company as defined in 1940 Act §2(a)(19).
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composed entirely of directors that meet the independence standards of both NYSE Rule
303A.02 and 1934 Act Rule 10A-3. The Commentary to NYSE Rule 303A.06 states: “The
[NYSE] will apply the requirements of SEC Rule 10A-3 in a manner consistent with the
guidance provided by the Securities and Exchange Commission in SEC Release No. 34-47654
(April 1, 2003). Without limiting the generality of the foregoing, the [NYSE] will provide
companies with the opportunity to cure defects provided in SEC Rule 10A-3(a)(3).”
The Commentary to NYSE Rule 303A.07 requires that each member of the audit
committee be financially literate, as such qualification is interpreted by the board in its business
judgment, or become financially literate within a reasonable period of time after his or her
appointment to the audit committee. In addition, at least one member of the audit committee
must have accounting or related financial management expertise, as the NYSE listed company’s
board interprets such qualification in its business judgment. While the NYSE does not require an
NYSE listed company’s audit committee to include a person who satisfies the definition of audit
committee financial expert set forth in Item 401(h) of Regulation S-K, a board may presume that
such a person has accounting or related financial management experience.
If an audit committee member simultaneously serves on the audit committee of more than
three public companies, and the NYSE listed company does not limit the number of audit
committees on which its audit committee members serve to three or less, each board is required
to determine that such simultaneous service does not impair the ability of such board member to
effectively serve on the NYSE listed company’s audit committee and to disclose such
determination.
(ii)
Audit Committee Charter and Responsibilities. NYSE Rule 303A.07(c)
requires the audit committee of each NYSE listed company to have a written audit committee
charter that addresses: (i) the committee’s purpose; (ii) an annual performance evaluation of the
audit committee; and (iii) the duties and responsibilities of the audit committee (“NYSE Audit
Committee Charter Provision”).
The NYSE Audit Committee Charter Provision provides details as to the duties and
responsibilities of the audit committee that must be addressed. These include, at a minimum,
those set out in 1934 Act Rule 10A-3(b)(2), (3), (4) and (5), as well as the responsibility to at
least annually obtain and review a report by the independent auditor; meet to review and discuss
the company’s annual audited financial statements and quarterly financial statements with
management and the independent auditor, including reviewing the NYSE listed company’s
specific disclosures under MD&A; discuss the company’s earnings press releases, as well as
financial information and earnings guidance provided to analysts and rating agencies; discuss
policies with respect to risk assessment and risk management; meet separately, periodically, with
management, with internal auditors (or other personnel responsible for the internal audit
function), and with independent auditors; review with the independent auditors any audit
problems or difficulties and management’s response; set clear hiring policies for employees or
former employees of the independent auditors; and report regularly to the board. The
commentary to NYSE Rule 303A.07 explicitly states that the audit committee functions
specified in NYSE Rule 303A.07 are the sole responsibility of the audit committee and may not
be allocated to a different committee.
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Each NYSE listed company must have an internal audit function. The commentary to
NYSE Rule 303A.07 states that listed companies must maintain an internal audit function to
provide management and the audit committee with ongoing assessments of the NYSE listed
company’s risk management processes and system of internal control. A NYSE listed company
may choose to outsource this function to a third party service provider other than its independent
auditor.
(3)
NASDAQ.
(i)
Audit Committee Composition. NASD Rule 4350(d) requires each
NASDAQ listed issuer to have an audit committee composed of at least three members. In
addition, it requires each audit committee member to: (1) be independent, as defined under
NASD Rule 4200(a)(15); (2) meet the criteria for independence set forth in 1934 Act Rule 10A-3
(subject to the exceptions provided in 1934 Act Rule10A-3(c)); (3) not have participated in the
preparation of the financial statements of the company or any current subsidiary of the company
at any time during the past three years; and (4) be able to read and understand fundamental
financial statements, including a company’s balance sheet, income statement, and cash flow
statement (“NASDAQ Audit Committee Provision”).
One director who is not independent as defined in NASD Rule 4200(a)(15) and meets the
criteria set forth in 1934 Act § 10A(m)(3) and the rules thereunder, and is not a current officer or
employee of the company or a family member of such person, may be appointed to the audit
committee if the board, under exceptional and limited circumstances, determines that
membership on the committee by the individual is required by the best interests of the company
and its shareholders, and the board discloses, in the next annual proxy statement subsequent to
such determination (or, if the issuer does not file a proxy, in its Form 10-K or 20-F), the nature of
the relationship and the reasons for that determination. A member appointed under this
exception would not be permitted to serve longer than two years and would not be permitted to
chair the audit committee. The NASDAQ Interpretive Material recommends that an issuer
disclose in its annual proxy (or, if the issuer does not file a proxy, in its Form 10-K or 20-F) if
any director is deemed independent but falls outside the safe harbor provisions of SEC Rule
10A-3(e)(1)(ii).
At least one member of the audit committee must have past employment experience in
finance or accounting, requisite professional certification in accounting, or any other comparable
experience or background which results in the individual’s financial sophistication, including
being or having been a chief executive officer, chief financial officer or other senior officer with
financial oversight responsibilities.
(ii)
Audit Committee Charter and Responsibilities. NASD Rule 4350(d)
requires each NASDAQ listed company to adopt a formal written audit committee charter and to
review and reassess the adequacy of the formal written charter on an annual basis. The charter
must specify: (1) the scope of the audit committee’s responsibilities, and how it carries out those
responsibilities, including structure, processes, and membership requirements; (2) the audit
committee’s responsibility for ensuring its receipt from the outside auditors of a formal written
statement delineating all relationships between the auditor and the company, and the audit
committee’s responsibility for actively engaging in a dialogue with the auditor with respect to
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any disclosed relationships or services that may impact the objectivity and independence of the
auditor and for taking, or recommending that the full board take, appropriate action to oversee
the independence of the outside auditor; (3) the committee’s purpose of overseeing the
accounting and financial reporting processes of the issuer and the audits of the financial
statements of the issuer; and (4) other specific audit committee responsibilities and authority set
forth in NASD Rule 4350(d)(3). NASDAQ states in the NASDAQ Interpretive Material to
NASD Rule 4350(d) that the written charter sets forth the scope of the audit committee’s
responsibilities and the means by which the committee carries out those responsibilities; the
outside auditor’s accountability to the committee; and the committee’s responsibility to ensure
the independence of the outside auditors.
c.
Nominating Committee Member Independence.
(1)
NYSE. NYSE Rule 303A.04 requires each NYSE listed company to have a
nominating/corporate governance committee composed entirely of independent directors. The
nominating/corporate governance committee must have a written charter that addresses, among
other items, the committee’s purpose and responsibilities, and an annual performance evaluation
of the nominating/corporate governance committee (“NYSE Nominating/Corporate Governance
Committee Provision”). The committee is required to identify individuals qualified to become
board members, consistent with the criteria approved by the board.
(2)
NASDAQ. NASD Rule 4350(c)(4)(A) requires director nominees to be selected,
or recommended for the board’s selection, either by a majority of independent directors, or by a
nominations committee comprised solely of independent directors (“NASDAQ Director
Nomination Provision”).
If the nominations committee is comprised of at least three members, one director, who is
not independent (as defined in NASD Rule 4200(a)(15)) and is not a current officer or employee
or a family member of such person, is permitted to be appointed to the committee if the board,
under exceptional and limited circumstances, determines that such individual’s membership on
the committee is required by the best interests of the company and its shareholders, and the board
discloses, in its next annual meeting proxy statement subsequent to such determination (or, if the
issuer does not file a proxy, in its Form 10-K or 20-F), the nature of the relationship and the
reasons for the determination. A member appointed under such exception is not permitted to
serve longer than two years.
Further, NASD Rule 4350(c)(4)(B) requires each NASDAQ listed company to certify
that it has adopted a formal written charter or board resolution, as applicable, addressing the
nominations process and such related matters as may be required under the federal securities
laws. The NASDAQ Director Nomination Provision does not apply in cases where either the
right to nominate a director legally belongs to a third party, or the company is subject to a
binding obligation that requires a director nomination structure inconsistent with this provision
and such obligation pre-dates the date the provision was approved.
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d.
Compensation Committee Member Independence.
(1)
NYSE. NYSE Rule 303A.05 requires each NYSE listed company to have a
compensation committee composed entirely of independent directors. The compensation
committee must have a written charter that addresses, among other items, the committee’s
purpose and responsibilities, and an annual performance evaluation of the compensation
committee (“NYSE Compensation Committee Provision”). The Compensation Committee is
required to produce a compensation committee report on executive compensation, as required by
SEC rules, to be included in the company’s annual proxy statement or annual report on Form 10K filed with the SEC. NYSE Rule 303A.05 provides that either as a committee or together with
the other independent directors (as directed by the Board), the committee will determine and
approve the CEO’s compensation level based on the committee’s evaluation of the CEO’s
performance. The commentary to this rule indicates that discussion of CEO compensation with
the board generally is not precluded.
(2)
NASDAQ. NASD Rule 4350(c)(3) requires the compensation of the CEO of a
NASDAQ listed company to be determined or recommended to the board for determination
either by a majority of the independent directors, or by a compensation committee comprised
solely of independent directors (“NASDAQ Compensation of Executives Provision”). The CEO
may not be present during voting or deliberations. In addition, the compensation of all other
officers has to be determined or recommended to the Board for determination either by a
majority of the independent directors, or a compensation committee comprised solely of
independent directors.
Under these NASD Rules, if the compensation committee is comprised of at least three
members, one director, who is not “independent” (as defined in NASD Rule 4200(a)(15)) and is
not a current officer or employee or a family member of such person, is permitted to be
appointed to the committee if the board, under exceptional and limited circumstances, determines
that such individual’s membership on the committee is required by the best interests of the
company and its shareholders, and the Board discloses, in the next annual meeting proxy
statement subsequent to such determination (or, if the issuer does not file a proxy statement, in
its Form 10-K or 20-F), the nature of the relationship and the reasons for the determination. A
member appointed under such exception would not be permitted to serve longer than two years.
e.
State Law.
Under state law and unlike the SOX rules, director independence is not considered as a
general status, but rather is tested in the context of each specific matter on which the director is
called upon to take action.
Under Texas common law, a director is generally considered “interested” only in respect
of matters in which he has a financial interest. The Fifth Circuit in Gearhart summarized Texas
law with respect to the question of whether a director is “interested” as follows:
A director is considered ‘interested’ if he or she (1) makes a personal profit from
a transaction by dealing with the corporation or usurps a corporate opportunity
. . .; (2) buys or sells assets of the corporation . . .; (3) transacts business in his
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director’s capacity with a second corporation of which he is also a director or
significantly financially associated . . .; or (4) transacts business in his director’s
capacity with a family member.131
In the context of the dismissal of a derivative action on motion of the corporation, those
making the decision on behalf of the corporation to dismiss the proceeding must lack both any
disqualifying financial interest and any relationships that would impair independent decision
making. The Texas Corporate Statues provide that a court shall dismiss a derivative action if the
determination to dismiss is made by directors who are both disinterested and independent.132 For
this purpose, a director is considered “disinterested”133 if he lacks any disqualifying financial
interest in the matter, and is considered “independent”134 if he is both disinterested and lacks any
131
132
133
134
Gearhart, 741 F.2d at 719-20 (citations omitted).
TBOC § 21.554, 21.558; TBCA art. 5.14F and 5.14H.
TBOC § 1.003 defines “disinterested” as follows:
Sec. 1.003. DISINTERESTED PERSON.
(a) For purposes of this code, a person is disinterested with respect to the approval of a contract, transaction, or other
matter or to the consideration of the disposition of a claim or challenge relating to a contract, transaction, or
particular conduct, if the person or the person’s associate:
(1) is not a party to the contract or transaction or materially involved in the conduct that is the
subject of the claim or challenge; and
(2) does not have a material financial interest in the outcome of the contract or transaction or the
disposition of the claim or challenge.
(b) For purposes of Subsection (a), a person is not materially involved in a contract or transaction that is the subject of
a claim or challenge and does not have a material financial interest in the outcome of a contract or transaction or
the disposition of a claim or challenge solely because:
(1) the person was nominated or elected as a governing person by a person who is:
(A) interested in the contract or transaction; or
(B) alleged to have engaged in the conduct that is the subject of the claim or challenge;
(2) the person receives normal fees or customary compensation, reimbursement for expenses, or
benefits as a governing person of the entity;
(3) the person has a direct or indirect equity interest in the entity;
(4) the entity has, or its subsidiaries have, an interest in the contract or transaction or was affected
by the alleged conduct;
(5) the person or an associate of the person receives ordinary and reasonable compensation for
reviewing, making recommendations regarding, or deciding on the disposition of the claim or
challenge; or
(6) in the case of a review by the person of the alleged conduct that is the subject of the claim or
challenge:
(A) the person is named as a defendant in the derivative proceeding regarding the matter or as
a person who engaged in the alleged conduct; or
(B) the person, acting as a governing person, approved, voted for, or acquiesced in the act
being challenged if the act did not result in a material personal or financial benefit to the
person and the challenging party fails to allege particular facts that, if true, raise a
significant prospect that the governing person would be held liable to the entity or its
owners or members as a result of the conduct.
TBCA art. 1.02A(12) provides substantially the same.
TBOC § 1.004 defines “independent” as follows:
Sec. 1.004. INDEPENDENT PERSON.
(a) For purposes of this code, a person is independent with respect to considering the disposition of a claim or
challenge regarding a contract or transaction, or particular or alleged conduct, if the person:
(1) is disinterested;
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other specified relationships that could be expected to materially and adversely affect his
judgment as to the disposition of the matter.
Under Delaware law, an “independent director” is one whose decision is based on the
corporate merits of the subject before the board rather than extraneous considerations or
influence.135 The Delaware Supreme Court’s teachings on independence can be summarized as
follows:
At bottom, the question of independence turns on whether a director is, for any
substantial reason, incapable of making a decision with only the best interests of
the corporation in mind. That is, the Supreme Court cases ultimately focus on
impartiality and objectivity.136
135
136
(2) either:
(A) is not an associate, or member of the immediate family, of a party to the contract or
transaction or of a person who is alleged to have engaged in the conduct that is the
subject of the claim or challenge; or
(B) is an associate to a party or person described by Paragraph (A) that is an entity if the
person is an associate solely because the person is a governing person of the entity or of
the entity’s subsidiaries or associates;
(3) does not have a business, financial, or familial relationship with a party to the contract or
transaction, or with another person who is alleged to have engaged in the conduct, that is the
subject of the claim or challenge that could reasonably be expected to materially and adversely
affect the judgment of the person in favor of the party or other person with respect to the
consideration of the matter; and
(4) is not shown, by a preponderance of the evidence, to be under the controlling influence of a
party to the contract or transaction that is the subject of the claim or challenge or of a person who is
alleged to have engaged in the conduct that is the subject of the claim or challenge.
(b) For purposes of Subsection (a), a person does not have a relationship that could reasonably be expected to
materially and adversely affect the judgment of the person regarding the disposition of a matter that is the subject
of a claim or challenge and is not otherwise under the controlling influence of a party to a contract or transaction
that is the subject of a claim or challenge or that is alleged to have engaged in the conduct that is the subject of a
claim or challenge solely because:
(1) the person has been nominated or elected as a governing person by a person who is interested in
the contract or transaction or alleged to be engaged in the conduct that is the subject of the claim or
challenge;
(2) the person receives normal fees or similar customary compensation, reimbursement for
expenses, or benefits as a governing person of the entity;
(3) the person has a direct or indirect equity interest in the entity;
(4) the entity has, or its subsidiaries have, an interest in the contract or transaction or was affected
by the alleged conduct;
(5) the person or an associate of the person receives ordinary and reasonable compensation for
reviewing, making recommendations regarding, or deciding on the disposition of the claim or
challenge; or
(6) the person, an associate of the person, other than the entity or its associates, or an immediate
family member has a continuing business relationship with the entity that is not material to the
person, associate, or family member.
TBCA art. 1.02A(15) provides substantially the same.
Aronson v. Lewis, 473 A.2d 805, 816 (Del. 1984) (overruled as to standard of appellate review); Odyssey Partners v.
Fleming Companies, 735 A.2d 386 (Del. Ch. 1999).
Parfi Holding AB v. Mirror Image Internet, Inc., 794 A.2d 1211, 1232 (Del. Ch. 2001) (footnotes omitted) (emphasis in
original), rev’d in part on other grounds, 817 A.2d 149 (Del. 2002), cert. denied, 123 S. Ct. 2076 (2003).
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The Delaware focus includes both financial and other disabling interests.137 In the words
of the Chancery Court:
Delaware law should not be based on a reductionist view of human nature
that simplifies human motivations on the lines of the least sophisticated notions of
the law and economics movement. Homo sapiens is not merely homo
economicus. We may be thankful that an array of other motivations exist that
influence human behavior; not all are any better than greed or avarice, think of
envy, to name just one. But also think of motives like love, friendship, and
collegiality, think of those among us who direct their behavior as best they can on
a guiding creed or set of moral values.138
137
138
See In Re: INFOUSA, Inc. Shareholders Litigation, CA No. 1956-CC (Del. Ch. August 20, 2007) (mere allegations of
personal liability in respect of challenged activities are not sufficient to impair independence, but independence may be
found lacking where there is a substantial likelihood that liability will be found).
In Re Oracle Corp. Derivative Litigation, 824 A.2d 917, 2003 WL 21396449 (Del. Ch. 2003). In Oracle, the Chancery
Court denied a motion by a special litigation committee of Oracle Corporation to dismiss pending derivative actions
which accused four Oracle directors and officers of breaching their fiduciary duty of loyalty by misappropriating inside
information in selling Oracle stock while in possession of material, nonpublic information that Oracle would not meet
its projections. These four directors were Oracle’s CEO, its CFO, the Chair of the Executive, Audit and Finance
Committees, and the Chair of the Compensation Committee who was also a tenured professor at Stanford University.
The other members of Oracle’s board were accused of a breach of their Caremark duty of oversight through
indifference to the deviation between Oracle’s earnings guidance and reality.
In response to this derivative action and a variety of other lawsuits in other courts arising out of its surprising the
market with a bad earnings report, Oracle created a special litigation committee to investigate the allegations and
decide whether Oracle should assume the prosecution of the insider trading claims or have them dismissed. The
committee consisted of two new outside directors, both tenured Stanford University professors, one of whom was
former SEC Commissioner Joseph Grundfest. The new directors were recruited by the defendant CFO and the
defendant Chair of Compensation Committee/Stanford professor after the litigation had commenced and to serve as
members of the special litigation committee.
The Chancery Court held that the special committee failed to meet its burden to prove that no material issue of fact
existed regarding the special committee’s independence due to the connections that both the committee members and
three of four defendants had to Stanford. One of the defendants was a Stanford professor who taught special committee
member Grundfest when he was a Ph.D. candidate, a second defendant was an involved Stanford alumnus who had
contributed millions to Stanford, and the third defendant was Oracle’s CEO who had donated millions to Stanford and
was considering a $270 million donation at the time the special committee members were added to the Oracle board.
The two Stanford professors were tenured and not involved in fund raising for Stanford, and thus were not dependent
on contributions to Stanford for their continued employment.
The Court found troubling that the special litigation committee’s report recommending dismissal of the derivative
action failed to disclose many of the Stanford ties between the defendants and the special committee. The ties emerged
during discovery.
Without questioning the personal integrity of either member of the special committee, the Court found that
interrelationships among Stanford University, the special committee members and the defendant Oracle directors and
officers necessarily would have colored in some manner the special committee’s deliberations. The Court commented
that it is no easy task to decide whether to accuse a fellow director of the serious charge of insider trading and such
difficulty was compounded by requiring the committee members to consider accusing a fellow professor and two large
benefactors of their university of conduct that is rightly considered a violation of criminal law.
The Chancery Court wrote that the question of independence “turns on whether a director is, for any substantial
reason, incapable of making a decision with only the best interests of the corporation in mind.” That is, the
independence test ultimately “focus[es] on impartiality and objectivity.” While acknowledging a difficulty in
reconciling Delaware precedent, the Court declined to focus narrowly on the economic relationships between the
members of the special committee and the defendant officers and directors - i.e. “treating the possible effect on one’s
personal wealth as the key to an independence inquiry.” Commenting that “homo sapiens is not merely homo
economicus,” the Chancery Court wrote, “Whether the [special committee] members had precise knowledge of all the
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Delaware draws a distinction between director disinterest and director independence. A
director is “interested” when he or she stands on both sides of a transaction, or will benefit or
experience some detriment that does not flow to the corporation or the stockholders generally.
Absent self-dealing, the benefit must be material to the individual director.139 In contrast, a
director is not “independent” where the director’s decision is based on “extraneous
considerations or influences” and not on the “corporate merits of the subject.”140 Employment or
consulting relationships can impair independence.141 A director who is a partner of a law firm
that receives substantial fees from the corporation may not be independent.142 Family
139
140
141
142
facts that have emerged is not essential, what is important is that by any measure this was a social atmosphere painted
in too much vivid Stanford Cardinal red for the [special committee] members to have reasonably ignored.”
Orman v. Cullman, 794 A.2d 5 (Del. Ch. 2002).
Orman v. Cullman, 794 A.2d 5 (Del. Ch. 2002).
See In re Ply Gem Indus., Inc. S’holders Litig., C.A. No. 15779-NC, 2001 Del. Ch. LEXIS 84 (Del. Ch. 2001) (holding
plaintiffs raised reasonable doubt as to directors’ independence where (i) interested director as Chairman of the Board
and CEO was in a position to exercise considerable influence over directors serving as President and COO; (ii) director
was serving as Executive Vice President; (iii) a director whose small law firm received substantial fees over a period of
years; and (iv) directors receiving substantial consulting fees); Goodwin v. Live Entertainment, Inc., 1999 WL 64265
(Del. Ch. 1999) (stating on motion for summary judgment that evidence produced by plaintiff generated a triable issue
of fact regarding whether directors’ continuing employment relationship with surviving entity created a material
interest in merger not shared by the stockholders); Orman v. Cullman, 794 A.2d 5 (Del. Ch. 2002) (questioning the
independence of one director who had a consulting contract with the surviving corporation and questioning the
disinterestedness of another director whose company would earn a $3.3 million fee if the deal closed); In re The Ltd.,
Inc. S’holders Litig., 2002 Del. Ch. LEXIS 28, 2002 WL 537692 (Del. Ch. March 27, 2002) (finding, in context of
demand futility analysis, that the plaintiffs cast reasonable doubt on the independence of certain directors in a
transaction that benefited the founder, Chairman, CEO and 25% stockholder of the company, where one director
received a large salary for his management positions in the company’s wholly-owned subsidiary, one director received
consulting fees, and another director had procured, from the controlling stockholder, a $25 million grant to the
university where he formerly served as president); Biondi v. Scrushy, C.A. No. 19896, 2003 Del. Ch. LEXIS 7 (Del.
Ch. Jan. 16, 2003) (questioning the independence of two members of a special committee formed to investigate charges
against the CEO because committee members served with the CEO as directors of two sports organizations and
because the CEO and one committee member had “long-standing personal ties” that included making large
contributions to certain sports programs); In Re: INFOUSA, Inc. Shareholders Litigation, CA No. 1956-CC (Del. Ch.
August 20, 2007) (in case where self dealing transactions by 41% stockholder were challenged on duty of loyalty
grounds, independence found lacking as to (i) director who was a professor in university business school named after
the 41% stockholder and received substantial compensation from the university and (ii) directors who received free
office space from the company for non-company uses).
In Re: INFOUSA, Inc. Shareholders Litigation, CA No. 1956-CC (Del. Ch. August 20, 2007) (The threat of withdrawal
of legal business found to be enough to raise a reasonable doubt as to a director’s independence where annual payments
listed in the complaint come close to or exceed a reasonable estimate of the annual yearly income per partner of the law
firm; the Court commented:
“Legal partnerships normally base the pay and prestige of their members upon the amount of revenue that
partners (and, more importantly, their clients) bring to their firms. Indeed, with law becoming an ever-more
competitive business, there is a notable trend for partners who fail to meet expectations to risk a loss of equity
in their firms. The threat of withdrawal of one partner’s worth of revenue from a law firm is arguably
sufficient to exert considerable influence over a named partner such that . . . his independence may be called
into question.”)
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relationships can also impair independence.143 Other business relationships may also prevent
independence.144
A controlled director is not an independent director.145 Control over individual directors
is established by facts demonstrating that “through personal or other relationships the directors
are beholden to the controlling person.”146
4.
Compensation.
a.
Prohibition on Loans to Directors or Officers.
SOX §402 generally prohibits, effective July 30, 2002, a corporation from directly or
indirectly making or arranging for personal loans to its directors and executive officers.147 Four
143
144
145
146
147
See Chaffin v. GNI Group, Inc., C.A. No. 16211, 1999 Del. Ch. LEXIS 182 (Del. Ch. Sept. 3, 1999) (finding that
director lacked independence where a transaction benefited son financially); Harbor Fin. Partners v. Huizenga, 751
A.2d 879 (Del. Ch. 1999) (holding that director who was brother-in-law of CEO and involved in various businesses
with CEO could not impartially consider a demand adverse to CEO’s interests); Mizel v. Connelly, C.A. No. 16638,
1999 Del. Ch. LEXIS 157 (Del. Ch. July 22, 1999) (holding director could not objectively consider demand adverse to
interest of grandfather).
See Kahn v. Tremont Corp., 694 A.2d 422 (Del. 1997) (holding members of special committee had significant prior
business relationship with majority stockholder such that the committee lacked independence triggering entire
fairness); Heineman v. Datapoint Corp., 611 A.2d 950 (Del. 1992) (holding that allegations of “extensive interlocking
business relationships” did not sufficiently demonstrate the necessary “nexus” between the conflict of interest and
resulting personal benefit necessary to establish directors’ lack of independence) (overruled as to standard of appellate
review); and see Citron v. Fairchild Camera & Instr. Corp., 569 A.2d 53 (Del. 1989) (holding mere fact that a
controlling stockholder elects a director does not render that director non-independent).
In re MAXXAM, Inc., 659 A.2d 760, 773 (Del. Ch. 1995) (“To be considered independent, a director must not be
dominated or otherwise controlled by an individual or entity interested in the transaction”).
Aronson, supra, 473 A.2d at 815; compare In re The Limited, Inc. S’holders Litig., 2002 Del. Ch. LEXIS 28, 2002 WL
537692 (Del. Ch. Mar. 27, 2002) (concluding that a university president who had solicited a $25 million contribution
from a corporation’s President, Chairman and CEO was not independent of that corporate official in light of the sense
of “owingness” that the university president might harbor with respect to the corporate official), and Lewis v. Fuqua,
502 A.2d 962, 966-67 (Del. Ch. 1985) (finding that a special litigation committee member was not independent where
the committee member was also the president of a university that received a $10 million charitable pledge from the
corporation’s CEO and the CEO was a trustee of the university), with In re Walt Disney Co. Derivative Litig., 731 A.2d
342, 359 (Del. Ch. 1998) (deciding that the plaintiffs had not created reasonable doubt as to a director’s independence
where a corporation’s Chairman and CEO had given over $1 million in donations to the university at which the director
was the university president and from which one of the CEO’s sons had graduated), aff’d in part, rev’d in part sub nom.
Brehm v. Eisner, 746 A.2d 244 (Del. 2000) and Bream v. Martha Stewart, 845 A.2d 1040 (Del. 2004) (“bare social
relationships clearly do not create reasonable doubt of independence”; the Supreme Court in distinguishing Bream from
Oracle, wrote “[u]nlike the demand-excusal context [of Bream], where the board is presumed to be independent, the
SLC [special litigation committee in Oracle] has the burden of establishing its own independence by a yardstick that
must be ‘like Caesar’s wife’ – ‘above reproach.’ Moreover, unlike the presuit demand context, the SLC analysis
contemplates not only a shift in the burden of persuasion but also the availability of discovery into various issues,
including independence”).
SOX §402(a) provides: “It shall be unlawful for any issuer (as defined in [SOX §2]), directly or indirectly, including
through any subsidiary, to extend or maintain credit, to arrange for the extension of credit, or to renew an extension of
credit, in the form of a personal loan to or for any director or executive officer (or equivalent thereof) of that issuer. An
extension of credit maintained by the issuer on the date of enactment of this subsection shall not be subject to the
provisions of this subsection, provided that there is no material modification to any term of any such extension of credit
or any renewal of any such extension of credit on or after that date of enactment.”
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categories of personal loans by an issuer to its directors and officers are expressly exempt from
SOX §402’s prohibition:148
(1)
any extension of credit existing before the SOX’s enactment as long as no
material modification or renewal of the extension of credit occurs on or after the date of SOX’s
enactment (July 30, 2002);
(2)
specified home improvement and consumer credit loans if:
•
•
•
(3)
made in the ordinary course of the issuer’s consumer credit business,
of a type generally made available to the public by the issuer, and
on terms no more favorable than those offered to the public;
loans by a broker-dealer to its employees that:
•
•
•
fulfill the three conditions of paragraph (2) above,
are made to buy, trade or carry securities other than the broker-dealer’s
securities, and
are permitted by applicable Federal Reserve System regulations; and
(4)
loans made or maintained by depository institutions that are insured by the U.S.
Federal Deposit Insurance Corporation “if the loans are subject to the insider lending restrictions
of section 22(h) of the Federal Reserve Act (12 U.S.C. 375b).”149
The SEC to date has not provided guidance as to the interpretation of SOX §402,
although a number of interpretative issues have surfaced. The prohibitions of SOX §402 apply
only to an extension of credit “in the form of a personal loan” which suggests that all extensions
of credit to a director or officer are not proscribed. While there is no legislative history or
statutory definition to guide, it is reasonable to take the position that the following in the
ordinary course of business are not proscribed: travel and similar advances, ancillary personal
use of company credit card or company car where reimbursement is required; advances of
relocation expenses ultimately to be borne by the issuer; stay and retention bonuses subject to
reimbursement if the employee leaves prematurely; advancement of expenses pursuant to typical
148
149
SEC
Release
No.
34-48481
(September
11,
2003),
which
can
be
found
at
http://www.sec.gov/rules/proposed/34-48481.htm.
This last exemption applies only to an “insured depository institution,” which is defined by the Federal Deposit
Insurance Act (“FDIA”) as a bank or savings association that has insured its deposits with the Federal Deposit
Insurance Corporation (“FDIC”). Although this SOX §402 provision does not explicitly exclude foreign banks from
the exemption, under current U.S. banking regulation a foreign bank cannot be an “insured depository institution” and,
therefore, cannot qualify for the bank exemption. Since 1991, following enactment of the Foreign Bank Supervision
Enhancement Act (“FBSEA”), a foreign bank that seeks to accept and maintain FDIC-insured retail deposits in the
United States must establish a U.S. subsidiary, rather than a branch, agency or other entity, for that purpose. These
U.S. subsidiaries of foreign banks, and the limited number of grandfathered U.S. branches of foreign banks that had
obtained FDIC insurance prior to FBSEA’s enactment, can engage in FDIC-insured, retail deposit activities and, thus,
qualify as “insured depository institutions.” But the foreign banks that own the U.S. insured depository subsidiaries or
operate the grandfathered insured depository branches are not themselves “insured depository institutions” under the
FDIA. The SEC, however, has proposed a rule to address this disadvantageous situation for foreign banks.
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charter, bylaw or contractual indemnification arrangements; and tax indemnification payments to
overseas-based officers.150
SOX §402 raises issues with regard to cashless stock option exercises and has led a
number of issuers to suspend cashless exercise programs. In a typical cashless exercise program,
the optionee delivers the notice of exercise to both the issuer and the broker, and the broker
executes the sale of some or all of the underlying stock on that day (T). Then, on or prior to the
settlement date (T+3), the broker pays to the issuer the option exercise price and applicable
withholding taxes, and the issuer delivers (i.e., issues) the option stock to the broker. The broker
transmits the remaining sale proceeds to the optionee. When and how these events occur may
determine the level of risk under SOX §402.151 The real question is whether a brokeradministered same-day sale involves “an extension of credit in the form of a personal loan” made
or arranged by the issuer. The nature of the arrangement can affect the analysis.152
Some practitioners have questioned whether SOX §402 prohibits directors and executive
officers of an issuer from taking loans from employee pension benefit plans, which raised the
further question of whether employers could restrict director and officer plan loans without
violating the U.S. Labor Department’s antidiscrimination rules. On April 15, 2003, the Labor
Department issued Field Assistance Bulletin 2003-1 providing that plan fiduciaries of public
companies could deny participant loans to directors and officers without violating the Labor
Department rules.
b.
Stock Exchange Requirements.
The stock exchanges require shareholder approval of many equity compensation plans.153
In contrast, state law generally authorizes such plans and leaves the power to authorize them
generally with the power of the board of directors to direct the management of the affairs of the
corporation.
150
151
152
153
See outline dated October 15, 2002, authored jointly by a group of 25 law firms and posted at
www.TheCorporateCounsel.net as “Sarbanes-Oxley Act: Interpretative Issues Under §402 – Prohibition of Certain
Insider Loans.”
See Cashless Exercise and Other SOXmania, The Corporate Counsel (September-October 2002).
If the issuer delivers the option stock to the broker before receiving payment, the issuer may be deemed to have loaned
the exercise price to the optionee, perhaps making this form of program riskier than others. If the broker advances
payment to the issuer prior to T+3, planning to reimburse itself from the sale of proceeds on T+3, that advance may be
viewed as an extension of credit by the broker, and the question then becomes whether the issuer “arranged” the credit.
The risk of this outcome may be reduced where the issuer does not select the selling broker or set up the cashless
exercise program, but instead merely confirms to a broker selected by the optionee that the option is valid and
exercisable and that the issuer will deliver the stock upon receipt of the option exercise price and applicable
withholding taxes. Even where the insider selects the broker, the broker cannot, under Regulation T, advance the
exercise price without first confirming that the issuer will deliver the stock promptly. In that instance, the issuer’s
involvement is limited to confirming facts, and therefore is less likely to be viewed as “arranging” the credit.
Where both payment and delivery of the option stock occur on the same day (T+3), there arguably is no extension of
credit at all, in which case the exercise should not be deemed to violate SOX §402 whether effected through a
designated broker or a broker selected by the insider.
If the insider has sufficient collateral in his or her account (apart from the stock underlying the option being exercised)
to permit the broker to make a margin loan equal to the exercise price and applicable withholding taxes, arguably the
extension of credit is between the broker and the insider, and does not violate SOX §402 assuming the issuer is not
involved in arranging the credit.
See NYSE Rule 312; NASD Rule 4350(i).
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c.
Fiduciary Duties.
In approving executive compensation, directors must act in accordance with their
fiduciary duties. The fiduciary duties discussed elsewhere herein, including the duties of care,
loyalty and disclosure, are all applicable when directors consider executive compensation
matters.154 As in other contexts, process and disinterested judgment are critical.
5.
Related Party Transactions.
a.
Stock Exchanges.
(1)
General. Stock exchange listing requirements generally require all related party
transactions to be approved by a committee of independent directors.155
(2)
NYSE. The NYSE, in NYSE Rule 307, takes the general position that a publiclyowned company of the size and character appropriate for listing on the NYSE should be able to
operate on its own merit and credit standing free from the suspicions that may arise when
business transactions are consummated with insiders. The NYSE feels that the company’s
management is in the best position to evaluate each such relationship intelligently and
objectively.
However, there are certain related party transactions that do require shareholder approval
under the NYSE Rules. Therefore, a review of NYSE Rule 312 should be done whenever related
party transactions are analyzed by a NYSE listed company.
(3)
NASDAQ. NASD Rule 4350(h) requires each NASDAQ listed company to
conduct an appropriate review of all related party transactions for potential conflict of interest
situations on an ongoing basis and all such transactions must be approved by the company’s
audit committee or another independent body of the board of directors. For purposes of this rule,
the term “related party transaction” shall refer to transactions required to be disclosed pursuant
to SEC Regulation S-K, Item 404.
b.
Interested Director Transactions —TBOC § 21.418; TBCA Art. 2.35-1; and
DGCL § 144.
Both Texas and Delaware have embraced the principle that a transaction or contract
between a director and the director’s corporation is presumed to be valid and will not be voidable
solely by reason of the director’s interest as long as certain conditions are met.
DGCL § 144 provides that a contract between a director and the director’s corporation
will not be voidable due to the director’s interest if (i) the transaction or contract is approved in
good faith by a majority of the disinterested directors after the material facts as to the
relationship or interest and as to the transaction or contract are disclosed or known to the
directors, (ii) the transaction or contract is approved in good faith by shareholders after the
material facts as to the relationship or interest and as to the transaction or contract is disclosed or
154
155
See notes 208-247 and related text, infra.
See NYSE Rules 307 and 312; NASD Rule 4350(h).
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known to the shareholders, or (iii) the transaction or contract is fair to the corporation as of the
time it is authorized, approved, or ratified by the directors or shareholders of the corporation.156
In Fliegler v. Lawrence, however, the Delaware Supreme Court held that where the votes of
directors, qua stockholders, were necessary to garner stockholder approval of a transaction in
which the directors were interested, the taint of director self-interest was not removed, and the
transaction or contract may still be set aside and liability imposed on a director if the transaction
is not fair to the corporation.157 The question remains, however, whether approval by a majority
of disinterested stockholders will, pursuant to DGCL § 144(a)(2), cure any invalidity of director
actions and, by virtue of the stockholder ratification, eliminate any director liability for losses
from such actions.158
In 1985, Texas followed Delaware’s lead in the area of interested director transactions
and adopted TBCA article 2.35-1,159 the predecessor to TBOC § 21.418. In general, these Texas
Corporate Statues provide that a transaction between a corporation and one or more of its
directors or officers will not be voidable solely by reason of that relationship if the transaction is
approved by shareholders or disinterested directors after disclosure of the interest, or if the
transaction is otherwise fair.160 Because TBCA art. 2.35-1, as initially enacted, was essentially
identical to DGCL § 144, some uncertainty on the scope of TBCA art. 2.35-1 arose because of
Fliegler’s interpretation of DGCL § 144. This imposition of a fairness gloss on the Texas statute
rendered the effect of the safe harbor provisions in TBCA article 2.35-1 uncertain.
In 1997, TBCA article 2.35-1 was amended to address the ambiguity created by Fliegler
and to clarify that contracts and transactions between a corporation and its directors and officers
or in which a director or officer has a financial interest are valid notwithstanding that interest as
long as any one of the following are met: (i) the disinterested directors of the corporation
approve the transaction after disclosure of the interest, (ii) the shareholders of the corporation
approve the transaction after disclosure of the interest or (iii) the transaction is fair.161 TBOC
§ 21.418 mirrors these clarifications. Under the Texas Corporate Statues, if any one of these
conditions is met, the contract will be considered valid notwithstanding the fact that the director
or officer has an interest in the transaction.162 These provisions rely heavily on the statutory
definitions of “disinterested” contained in TBCA art. 1.02 and TBOC § 1.003. Under these
definitions, a director will be considered “disinterested” if the director is not a party to the
contract or transaction or does not otherwise have a material financial interest in the outcome of
the contract.163
Article 2.35-1 also changed the general approach of the statute from a mere presumption
that a contract is not voidable by reason of the existence of an affiliated relationship if certain
conditions are met to an absolute safe harbor that provides that an otherwise valid contract will
156
157
158
159
160
161
162
163
DGCL § 144(a).
Fliegler v. Lawrence, 361 A.2d 218, 222 (Del. 1976).
See Michelson v. Duncan, 407 A.2d 211, 219 (Del. 1979).
TBOC § 21.418; TBCA art. 2.35-1.
Id; TBOC § 21.418; see Landon v. S&A Marketing Group, Inc., 82 S.W.2d 3rd 666 (Tx. App. Eastland 2002).
TBCA art. 2.35-1.
Id. art. 2.35-1(A); TBOC § 21.418(b).
Id.
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be valid if the specified conditions are met, a change retained by TBOC § 21.418. Although the
difference between the Texas and Delaware constructions is subtle, the distinction is significant
and provides more certainty as transactions are structured. However, these Texas Corporate
Statutes do not eliminate a director’s or officer’s fiduciary duty to the corporation.
III.
Shifting Duties When Company on Penumbra of Insolvency.
A.
Insolvency Changes Relationships.
Directors owe fiduciary duties to the corporation and its owners.164 When the corporation
is solvent, the directors owe fiduciary duties to the corporation and the shareholders of the
corporation.165 The creditors relationship to the corporation is contractual in nature. A solvent
corporation’s directors do not owe any fiduciary duties to the corporation’s creditors, whose
rights in relation to the corporation are those that they have bargained for and memorialized in
their contracts.166
In Texas a corporation’s directors continue to owe shareholders, not creditors, fiduciary
duties “so long as [the corporation] continues to be a going concern, conducting its business in
the ordinary way, without some positive act of insolvency, such as the filing of a bill to
administer its assets, or the making of a general assignment.”167 When the corporation is both
insolvent and has ceased doing business, the corporation’s creditors become its owners and the
directors owe fiduciary duties to the creditors as the owners of the business in the sense they
have a duty to administer the corporation’s remaining assets as a trust fund for the benefit of all
of the creditors.168 The duties of directors of an insolvent corporation to its creditors, however,
do not require that the directors must abandon their efforts to direct the affairs of the corporation
in a manner intended to benefit the corporation and its shareholders and that they lose the
protections of the business judgment rule.169 However, owing a duty of loyalty means that “a
164
165
166
167
168
169
Comments of Delaware Vice Chancellor Leo E. Strine in Galveston, Texas on February 22, 2002 at the 24th Annual
Conference on Securities Regulation and Business Law Problems sponsored by University of Texas School of Law,
et al.
North American Catholic Educational Programming Foundation Inc. v. Gheewalla, 930 A2d 92, 101, 2007 WL
1453705 (Del. 2007) (“The directors of Delaware corporations have ‘the legal responsibility to manage the business of
a corporation for the benefit of its shareholders owners’”, quoting from Malone v. Brincat, 722 A.2d 5 (1998)).
See Fagan v. La Gloria Oil & Gas Co., 494 S.W.2d 624, 628 (Tex. Civ. App.—Houston [14th Dist.] 1973, no writ)
(“[O]fficers and directors of a corporation owe to it duties of care and loyalty. … Such duties, however, are owed to the
corporation and not to creditors of the corporation.”)
Conway v. Bonner, 100 F.2d 786, 787 (5th Cir. 1939); see Floyd v. Hefner, 2006 WL 2844245 (S.D. Tex. Sept. 29,
2006); Askanase v. Fatjo, No. H-91-3140, 1993 WL 208440 (S.D. Tex. April 22, 1993); but see Carrieri v. Jobs.com,
393 F.3d 508, 534, n. 24 (5th Cir. 2004) (“[o]fficers and directors that are aware that the corporation is insolvent, or
within the ‘zone of insolvency’ … have expanded fiduciary duties to include the creditors of the corporation.”).
Floyd v. Hefner, 2006 WL 2844245 (S.D. Tex. Sept. 29, 2006); Askanase v. Fatjo, No. H-91-3140, 1993 WL 208440
(S.D. Tex. April 22, 1993); see also Hixson v. Pride of Texas Distrib. Co., 683 S.W.2d 173, 176 (Tex.App.–Fort Worth
1985, no writ); State v. Nevitt, 595 S.W.2d 140, 143 (Tex.App.–Dallas 1980, writ ref’d n.r.e.); and Fagan v. La Gloria
Oil & Gas. Co., 494 S.W.2d 624, 628 (Tex.App.–Houston [14th Dist.] 1973, no writ).
Floyd v. Hefner, 2006 WL 2844245 (S.D. Tex. Sept. 29, 2006), in which Judge Melinda Harmon concludes that “Texas
law does not impose fiduciary duties in favor of creditors on the directors of an insolvent, but still operating,
corporation, [but] it does require those directors to act as fiduciaries of the corporation itself” and that Gearhart
Industries, Inc. v. Smith International, Inc., 741 F.2d 707, 719 (5th Cir. 1984), remains the controlling statement of
Texas director fiduciary duty law; see Glenn D. West & Emmanuel U. Obi, Corporations, 60 SMU L. Rev. 885, 910911 (2007).
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self-interested director cannot orchestrate the sale of a corporation’s assets for his benefit below
the price that diligent marketing efforts would have obtained.”170 The trust fund doctrine in
Texas requires the directors and officers of an insolvent corporation to deal fairly with its
creditors without preferring one creditor over another or themselves to the injury of other
creditors.171 Even where they are not direct beneficiaries of fiduciary duties, the creditors of an
insolvent corporation may benefit from the fiduciary duties which continue to be owed to the
corporation.172
In Delaware, the corporation need not have ceased doing business for that trust fund to
arise and the directors to owe duties to creditors.173 However, the Delaware formulation of the
trust fund doctrine would not afford relief if the self-dealing was fair:
[C]reditors need protection even if an insolvent corporation is not liquidating,
because the fact of insolvency shifts the risk of loss from the stockholders to the
creditors. While stockholders no longer risk further loss, creditors become at risk
when decisions of the directors affect the corporation’s ability to repay debt. This
new fiduciary relationship is certainly one of loyalty, trust and confidence, but it
does not involve holding the insolvent corporation’s assets in trust for distribution
to creditors or holding directors strictly liable for actions that deplete corporate
assets.174
The trust fund doctrine does not preclude the directors from allowing the corporation to take on
economic risk for the benefit of the corporation’s equity owners.175 Rather, the shifting merely
170
171
172
173
174
175
Id.; cf. In re Performance Nutrition, Inc., 237 B.R. 93 (Bankr. N.D. Tex. 1999); In re General Homes Corp., 199 B.R.
148 (S.D. Tex. 1996).
Plas-Tex v. Jones, 2000 WL 632677 (Tex. App.-Austin 2002; not published in S.W.3d) (“As a general rule, corporate
officers and directors owe fiduciary duties only to the corporation and not to the corporation’s creditors, unless there
has been prejudice to the creditors. . . . However, when a corporation is insolvent, a fiduciary relationship arises
between the officers and directors of the corporation and its creditors, and creditors may challenge a breach of the
duty. . . . Officers and directors of an insolvent corporation have a fiduciary duty to deal fairly with the corporation’s
creditors, and that duty includes preserving the value of the corporate assets to pay corporate debts without preferring
one creditor over another or preferring themselves to the injury of other creditors. . . . However, a creditor may pursue
corporate assets and hold directors liable only for ‘that portion of the assets that would have been available to satisfy
his debt if they had been distributed pro rata to all creditors’.”); Geyer v. Ingersoll Pub. Co., 621 A. 2d 784, 787
(Del.Ch. 1992) (“[T]he general rule is that directors do not owe creditors duties beyond the relevant contractual terms
absent ‘special circumstances’ . . . e.g., fraud, insolvency or a violation of a statute….’ [citation omitted]. Furthermore,
[no one] seriously disputes that when the insolvency does arise, it creates fiduciary duties for directors for the benefit of
creditors. Therefore, the issue…is when do directors’ fiduciary duties to creditors arise via insolvency.”); see Terrell
and Short, Directors Duties in Insolvency: Lessons From Allied Riser, 14 BNA Bkr. L. Reptr. 293 (March 14, 2002).
Floyd v. Hefner, 2006 WL 2844245 (S.D. Tex. Sept. 29, 2006).
Askanase v. Fatjo, No. H-91-3140, 1993 WL 208440 (S.D. Tex. April 22, 1993); Geyer v. Ingersoll Pub. Co., 621 A.
2d 784, 787 (Del.Ch. 1992) (“[T]he general rule is that directors do not owe creditors duties beyond the relevant
contractual terms absent ‘special circumstances’ . . . e.g., fraud, insolvency or a violation of a statute….’ [citation
omitted]. Furthermore, [no one] seriously disputes that when the insolvency does arise, it creates fiduciary duties for
directors for the benefit of creditors. Therefore, the issue…is when do directors’ fiduciary duties to creditors arise via
insolvency.”); see Terrell and Short, Directors Duties in Insolvency: Lessons From Allied Riser, 14 BNA Bkr. L. Reptr.
293 (March 14, 2002).
Decker v. Mitchell (In re JTS Corp), 305 B.R. 529, 539 (Bankr. N.D. Cal. 2003).
North American Catholic Educational Programming Foundation Inc. v. Gheewalla, 930 A2d 92, 2007 WL 1453705
(Del. 2007); Floyd v. Hefner, 2006 WL 2844245 (S.D. Tex. Sept. 29, 2006); see Rutheford B. Campbell, Jr. and
Christopher W. Frost, Managers’ Fiduciary Duties in Financially Distressed Corporations: Chaos in Delaware (and
Elsewhere), 32 J. Corp. L. 492 (Spring 2007).
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exonerates the directors who choose to maintain the corporation’s long term viability by
considering the interests of creditors.176
There are degrees of insolvency (e.g., a corporation may be unable to pay its debts as
they come due because of troubles with its lenders or its liabilities may exceed the book value of
its assets, but the intrinsic value of the entity may significantly exceed its debts). Sometimes it is
unclear whether the corporation is insolvent. In circumstances where the corporation is on the
penumbra of insolvency, the directors may owe fiduciary duties to the “whole enterprise.”177
Owing fiduciary duties to the “whole enterprise” puts the directors in the uncomfortable position
of owing duties to the corporation that multiple constituencies having conflicting interests may
claim the right to enforce on behalf of the corporation.178
B.
When is a Corporation Insolvent or in the Vicinity of Insolvency?
In Delaware it is the fact of insolvency, rather than the commencement of statutory
bankruptcy or other insolvency proceedings, that causes the shift in the focus of director
176
177
178
Id.; see Equity-Linked Investors, L.P. v. Adams, 705 A.2d 1040, 1042 n.2 (Del. Ch. 1997) (“[W]here foreseeable
financial effects of a board decision may importantly fall upon creditors as well as holders of common stock, as where
corporation is in the vicinity of insolvency, an independent board may consider impacts upon all corporate
constituencies in exercising its good faith business judgment for benefit of the ‘corporation.’”).
Geyer v. Ingersoll Pub. Co., 621 A. 2d 784, 789 (Del.Ch. 1992) (“The existence of the fiduciary duties at the moment
of insolvency may cause directors to choose a course of action that best serves the entire corporate enterprise rather
than any single group interested in the corporation at a point in time when the shareholders’ wishes should not be the
directors only concern”); see Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., C.A. No. 12150,
1991 Del. Ch. LEXIS 215 at n. 55 (Del. Ch. 1991) in which Chancellor Allen expressed the following in dicta:
n. 55 The possibility of insolvency can do curious things to incentives, exposing creditors to risks
of opportunistic behavior and creating complexities for directors. Consider, for example, a solvent
corporation having a single asset, a judgment for $51 million against a solvent debtor. The judgment is
on appeal and thus subject to modification or reversal. Assume that the only liabilities of the company
are to bondholders in the amount of $12 million. Assume that [based on] the array of probable
outcomes of the appeal [25% chance of affirmance, 70% chance of modification and 5% chance of
reversal] the best evaluation is that the current value of the equity is $3.55 million. ($15.55 million
expected value of judgment on appeal $12 million liability to bondholders). Now assume an offer to
settle at $12.5 million (also consider one at $17.5 million). By what standard do the directors of the
company evaluate the fairness of these offers? The creditors of this solvent company would be in favor
of accepting either a $12.5 million offer or a $17.5 million offer. In either event they will avoid the 75%
risk of insolvency and default. The stockholders, however, will plainly be opposed to acceptance of a
$12.5 million settlement (under which they get practically nothing). More importantly, they very well
may be opposed to acceptance of the $17.5 million offer under which the residual value of the
corporation would increase from $3.5 to $5.5 million. This is so because the litigation alternative, with
its 25% probability of a $39 million outcome to them ($51 million - $12 million $39 million) has an
expected value to the residual risk bearer of $9.75 million ($39 million x 25% chance of affirmance),
substantially greater than the $5.5 million available to them in the settlement. While in fact the
stockholders’ preference would reflect their appetite for risk, it is possible (and with diversified
shareholders likely) that the shareholders would prefer rejection of both settlement offers.
But if we consider the community of interests that the corporation represents it seems apparent that
one should in this hypothetical accept the best settlement offer available providing it is greater than
$15.55 million, and one below that amount should be rejected. But that result will not be reached by a
director who thinks he owes duties directly to shareholders only. It will be reached by directors who are
capable of conceiving of the corporation as a legal and economic entity. Such directors will recognize
that in managing the business affairs of a solvent corporation in the vicinity of insolvency,
circumstances may arise when the right (both the efficient and the fair) course to follow for the
corporation may diverge from the choice that the stockholders (or the creditors, or the employees, or any
single group interested in the corporation) would make if given the opportunity to act.
See Odyssey Partners, L.P. v. Fleming Companies, Inc., 735 A.2d 386 (Del. Ch. 1999).
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duties.179 Delaware courts define insolvency as occurring when the corporation “is unable to pay
its debts as they fall due in the usual course of business . . . or it has liabilities in excess of a
reasonable market value of assets held.”180
Under the “balance sheet” test used for bankruptcy law purposes, insolvency is defined as
when an entity’s debts exceed the entity’s property at fair valuation,181 and the value at which the
assets carried for financial accounting or tax purposes is irrelevant.
Fair value of assets is the amount that would be realized from the sale of assets within a
reasonable period of time.182 Fair valuation is not liquidation or book value, but is the value of
the assets considering the age and liquidity of the assets, as well as the conditions of the trade.183
For liabilities, the fair value assumes that the debts are to be paid according to the present terms
of the obligations.
The directors duties, however, do not shift before the moment of insolvency. The
Delaware Supreme Court has explained: “When a solvent corporation is navigating in the zone
of insolvency, the focus for Delaware directors does not change: directors must continue to
discharge their fiduciary duties to the corporation and its shareholders by exercising their
business judgment in the best interests of the corporation for the benefit of its shareholder
owners.”184 In cases where the corporation has been found to be in the vicinity of insolvency,
the entity was in dire financial straits with a bankruptcy petition likely in the minds of the
directors.185
C.
Director Liabilities to Creditors.
The business judgment rule is applicable to actions of directors even while the
corporation is insolvent or on the penumbra thereof in circumstances where it would otherwise
have been applicable.186 Where directors are interested, their conduct will likewise be judged by
the standards that would have otherwise been applicable. A director’s stock ownership,
179
180
181
182
183
184
185
186
Geyer v. Ingersoll Pub. Co., 621 A. 2d 784, 789 (Del.Ch. 1992).
Id.
11 U.S.C. § 101(32) (2006). A “balance sheet” test is also used under the fraudulent transfer statutes of Delaware and
Texas. See DEL. CODE ANN. tit. 6, § 1302 and TEX. BUS. & COM. CODE § 24.003. For general corporate purposes,
TBOC § 1.002(39) defines insolvency as the “inability of a person to pay the person’s debts as they become due in the
usual course of business or affairs.” TBCA art. 1.02A(16) provides substantially the same. For transactions covered by
the U.C.C., TEX. BUS. & COM. CODE 1.201(23) (2001) defines an entity as “insolvent” who either has ceased to pay its
debts in the ordinary course of business or cannot pay its debts as they become due or is insolvent within the meaning
of the federal bankruptcy law.
Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772 (Del. Ch. 2004); Angelo, Gordon & Co., L.P.,
et al. v. Allied Riser Communications Corporation, et al., 2002 Del. Ch. LEXIS 11.
In re United Finance Corporation, 104 F.2d 593 (7th Cir. 1939).
North American Catholic Educational Programming Foundation Inc. v. Gheewalla, 930 A2d 92, 2007 WL 1453705
(Del. 2007); but cf. Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., C.A. No. 12150 Mem. Op.,
Del. Ch. LEXIS 215 (Del. Ch. 1991).
In the Credit Lyonnais case, supra, a bankruptcy petition had recently been dismissed, but the corporation continued to
labor “in the shadow of that prospect” Id. See also Equity-Linked Investors LP v. Adams, 705 A.2d 1040, 1041 (Del.
Ch. 1997) (corporation found to be on “lip of insolvency” where a bankruptcy petition had been prepared and it had
only cash sufficient to cover operations for one more week).
Angelo, Gordon & Co., L.P., et al. v. Allied Riser Communications Corporation, et al., 2002 Del. Ch. LEXIS 11.
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however, may call into question a director’s independence where the fiduciary duties are owed to
the creditors, for the stock ownership would tend to ally the director with the interests of the
shareholders rather than the creditors, but relatively insubstantial amounts of stock ownership
should not impugn a directors independence.187
In Pereira v. Cogan,188 a Chapter 7 trustee bought an adversary proceeding against
Marshall Cogan, the former CEO of a closely held Delaware corporation of which he was the
founder and majority stockholder, and the corporation’s other officers and directors for their
alleged self-dealing or breach of fiduciary duty.189 The U.S. District Court for the Southern
District of New York (“SDNY”) held inter alia, that (1) ratification by board of directors that was
not independent190 of compensation that the CEO had previously set for himself, without
adequate information-gathering, was insufficient to shift from CEO the burden of demonstrating
entire fairness of transaction; (2) corporate officers with knowledge of debtor’s improper
redemption of preferred stock from an unaffiliated stockholder and unapproved loans to the CEO
and related persons could be held liable on breach of fiduciary duty theory for failing to take
appropriate action; (3) directors, by abstaining from voting on challenged corporate
expenditures, could not insulate themselves from liability; (4) directors did not satisfy their
burden of demonstrating “entire fairness” of transactions, and were liable for any resulting
damages; (5) report prepared by corporation’s compensation committee on performance/salary of
CEO, which was prepared without advice of outside consultants and consisted of series of
conclusory statements concerning the value of services rendered by the CEO in obtaining
financing for the corporation was little more than an ipse dixit, on which corporate officers could
not rely;191 (6) term “redeem,” as used in DGCL § 160, providing that no corporation shall
187
188
189
190
191
Cf. Angelo, Gordon & Co., L.P., et al. v. Allied Riser Communications Corporation, et al., 2002 Del. Ch. LEXIS 11.
294 B.R. 449 (SDNY 2003).
“Once Cogan created the cookie jar—and obtained outside support for it—he could not without impunity take from it.
“The second and more difficult question posed by this lawsuit is what role the officers and directors should play when
confronted by, or at least peripherally aware of, the possibility that a controlling shareholder (who also happens to be
their boss) is acting in his own best interests instead of those of the corporation. Given the lack of public accountability
present in a closely held private corporation, it is arguable that such officers and directors owe a greater duty to the
corporation and its shareholders to keep a sharp eye on the controlling shareholder. At the very least, they must uphold
the same standard of care as required of officers and directors of public companies or private companies that are not so
dominated by a founder/controlling shareholder. They cannot turn a blind eye when the controlling shareholder goes
awry, nor can they simply assume that all’s right with the corporation without any exercise of diligence to ensure that
that is the case.
“As discussed later, it is found as a matter of fact that Trace was insolvent or in the vicinity of insolvency during most
of the period from 1995 to 1999, when Trace finally filed for bankruptcy. Trace’s insolvency means that Cogan and
the other director and officer defendants were no longer just liable to Trace and its shareholders, but also to Trace’s
creditors. In addition, the insolvency rendered certain transactions illegal, such as a redemption and the declaring of
dividends. It may therefore be further concluded that, in determining the breadth of duties in the situation as described
above, officers and directors must at the very least be sure that the actions of the controlling shareholder (and their
inattention thereto) do not run the privately held corporation into the ground.” Pereira v. Cogan, 294 B.R. at 463.
“Cogan also failed in his burden to demonstrate that the Committee or the Board was “independent” in connection with
the purported ratification of his compensation. Sherman, the only member of the Board not on Trace’s payroll, was a
long-time business associate and personal friend of Cogan, with whom he had other overlapping business interests.
Nelson, the only other member of the Committee, was Trace’s CFO and was dependent on Cogan both for his
employment and the amount of his compensation, as were Farace and Marcus, the other Board members who approved
the Committee’s ratification of Cogan’s compensation. There is no evidence that any member of the Committee or the
Board negotiated with Cogan over the amount of his compensation, much less did so at arm’s length.” Pereira v.
Cogan, 294 B.R. at 478.
“With regard to the ratification of Cogan’s compensation from 1988 to 1994, there is no evidence that the Board met to
discuss the ratification or that the Board actually knew what level of compensation they were ratifying. While Nelson
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redeem its shares when the capital of the corporation is impaired, was broad enough to include
transaction whereby corporation loaned money to another entity to purchase its shares, the other
entity used money to purchase shares, and the corporation then accepted shares as collateral for
loan; (7) officers and directors could not assert individual-based offsets as defenses to breach of
fiduciary duty claims; (8) the exculpatory clause in the corporation’s certificate of incorporation
which shields directors from liability to the corporation for breach of the duty of care, as
authorized by DGCL § 102(b)(7), was inapplicable because the trustee had brought the action for
the benefit of the creditors rather than the corporation; and (9) the business judgment rule was
not applicable because a majority of the challenged transactions were not the subject of board
action. The SDNY concluded that the trustee’s fiduciary duty and DGCL claims were in the
nature of equitable restitution, rather than legal damages, and denied defendants’ request for a
jury trial. The CEO was found liable for $44.4 million and then settled with the trustee. The
remaining defendants appealed to the Second Circuit.
On appeal the defendants raised a “sandstorm” of claims and ultimately prevailed. The
Second Circuit held in Pereira v. Farace192 that the defendants were entitled to a jury trial
because the trustee’s claims were principally a legal action for damages, rather than an equitable
claim for restitution or unjust enrichment, because the appealing defendants never possessed the
funds at issue (the CEO who had received the funds had previously settled with the trustee and
was not a party to the appeal). In remanding the case for a jury trial, the Second Circuit also held
(i) that the bankruptcy trustee stood in the shoes of the insolvent corporation and as such was
bound by the exculpatory provision in the corporation’s certificate of incorporation pursuant to
DGCL § 102(b)(7) which precluded shareholder claims based on mismanagement (i.e., the duty
of care)193 and (ii) that the SDNY did not properly apply the Delaware definition of insolvency
when it used a cash flow test of insolvency which projected into the future whether the
corporation’s capital will remain adequate over a period of time rather than the Delaware test
192
193
delivered a report on Cogan’s 1991-1994 compensation approximately two years prior to the ratification, on June 24,
1994, there is no evidence that the directors who ratified the compensation remembered that colloquy, nor that they
relied on their two-year-old memories of it in deciding the ratify Cogan’s compensation. The mere fact that Cogan had
successfully spearheaded extremely lucrative deals for Trace in the relevant years and up to the ratification vote is
insufficient to justify a blind vote in favor of compensation that may or may not be commensurate with those given to
similarly situated executives. Any blind vote is suspect in any case given the fact that Cogan dominated the Board.
“The most that the Board did, or even could do, based on the evidence presented, was to rely on the recommendation of
the Compensation Committee. They have not established reasonable reliance on the advice of the Compensation
Committee, then composed of Nelson and Sherman (two of the four non-interested Board members who ratified the
compensation). The Compensation Committee had never met. It did not seek the advice of outside consultants. The
“report” to the Board consisted of several conclusory statements regarding Cogan’s performance, without reference to
any attachments listing how much the compensation was or any schedule pitting that level of compensation against that
received by executives the Compensation Committee believed to be similarly situated. The “report” was little more
than an ipse dixit and it should have been treated accordingly by the Board. As a result, the director-defendants cannot
elude liability on the basis of reliance on the Compensation Committee’s report.” Pereira v. Cogan, 294 B.R. at 528.
413 F.3d 330 (2nd Cir. 2005).
Two other cases have held that director exculpation charter provisions adopted under DGCL § 102(b)(7) protect
directors from duty of care claims brought by creditors who were accorded standing to pursue fiduciary duty claims
against directors because the company was insolvent. Production Resources Group, L.L.C. v. NCT Group, Inc., 863
A.2d 772 (Del. Ch. 2004) (“[T]he fact of insolvency does not change the primary object of the director’s duties, which
is the firm itself. The firm’s insolvency simply makes the creditors the principal constituency injured by any fiduciary
breaches that diminish the firm’s value and logically gives them standing to pursue these claims to rectify that injury.”);
Continuing Creditors’ Committee of Star Telecommunications Inc. v. Edgecomb, 2004 WL 2980736 (D. Del. 2004).
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which looks solely at whether the corporation has been paying its bills on a timely basis and/or
whether its assets exceed its liabilities.
When the conduct of the directors is being challenged by the creditors on fiduciary duty
of loyalty grounds, the directors do not have the benefit of the statutes limiting director liability
in duty of care cases.194
D.
Deepening Insolvency.
Deepening insolvency as a legal theory can be traced to dicta in a 1983 Seventh Circuit
opinion that “the corporate body is ineluctably damaged by the deepening of its insolvency,”
which results from the “fraudulent prolongation of a corporation’s life beyond insolvency.”195 In
recent years some federal courts embraced deepening insolvency claims and predicted that
Delaware would recognize such a cause of action.196 In Trenwick America Litigation Trust v.
Ernst & Young LLP, et al.,197 the Delaware Court of Chancery in 2006 for the first time
addressed a cause of action for deepening insolvency and, confounding the speculation of the
federal courts, held that “put simply, under Delaware law, ‘deepening insolvency’ is no more of
a cause of action when a firm is insolvent than a cause of action for ‘shallowing profitability’
would be when a firm is solvent.” This holding, which was affirmed by the Delaware Supreme
Court on August 4, 2007, “on the basis of and for the reasons assigned by the Court of Chancery
in its opinion,” arose in the aftermath of two flawed public company acquisitions which were
blamed for the company’s troubles. In granting a motion to dismiss a claim for deepening
insolvency, Vice Chancellor Strine explained his reasoning as follows:
In the complaint, the [plaintiff] also has attempted to state a claim against
the former subsidiary directors for “deepening insolvency.” * * * Delaware law
does not recognize this catchy term as a cause of action, because catchy though
the term may be, it does not express a coherent concept. Even when a firm is
insolvent, its directors may, in the appropriate exercise of their business judgment,
take action that might, if it does not pan out, result in the firm being painted in a
deeper hue of red. The fact that the residual claimants of the firm at that time are
creditors does not mean that the directors cannot choose to continue the firm’s
operations in the hope that they can expand the inadequate pie such that the firm’s
creditors get a greater recovery. By doing so, the directors do not become a
guarantor of success. Put simply, under Delaware law, “deepening insolvency” is
no more of a cause of action when a firm is insolvent than a cause of action for
“shallowing profitability” would be when a firm is solvent. Existing equitable
causes of action for breach of fiduciary duty, and existing legal causes of action
194
195
196
197
Geyer v. Ingersoll Pub. Co., 621 A. 2d 784, 789 (Del.Ch. 1992).
Schacht v. Brown, 711 F.2d 1343, 1350 (7th Cir 1983); see Sabin Willett, The Shallows of Deepening Insolvency, 60
Bus. Law 549 (Feb. 2005).
Official Comm. of Unsecured Creditors v. R.F. Lafferty Co., Inc., 267 F.3d 340, 351 (3d Cir. 2001) (applying
Pennsylvania law); In re Exide v. Credit Suisse First Boston, 299 B.R. 732 (Bankr. D. Del. 2003); In re Scott Acq.
Corp., 344 B.R. 283 (Bankr. D. Del.); Stanziale v. Pepper Hamilton, LLP, (In re Student Fin. Corp.), 355 B.R. 539,
548 (D. Del. 2005).
906 A.2d 168 (Del. Ch. 2006).
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for fraud, fraudulent conveyance, and breach of contract are the appropriate
means by which to challenge the actions of boards of insolvent corporations.
Refusal to embrace deepening insolvency as a cause of action is required
by settled principles of Delaware law. So, too, is a refusal to extend to creditors a
solicitude not given to equityholders. Creditors are better placed than
equityholders and other corporate constituencies (think employees) to protect
themselves against the risk of firm failure.
The incantation of the word insolvency, or even more amorphously, the
words zone of insolvency should not declare open season on corporate fiduciaries.
Directors are expected to seek profit for stockholders, even at risk of failure. With
the prospect of profit often comes the potential for defeat.
The general rule embraced by Delaware is the sound one. So long as
directors are respectful of the corporation’s obligation to honor the legal rights of
its creditors, they should be free to pursue in good faith profit for the
corporation’s equityholders. Even when the firm is insolvent, directors are free to
pursue value maximizing strategies, while recognizing that the firm’s creditors
have become its residual claimants and the advancement of their best interests has
become the firm’s principal objective. [Slip opinion at 5-7]
The strength of the Trenwick holding is diluted by the Vice Chancellor’s finding that “the
complaint fails to plead facts supporting an inference that the subsidiary was insolvent before or
immediately after the challenged transactions.”
Also elucidating was the Vice Chancellor’s statement of the fiduciary duties of the
directors of a wholly owned subsidiary:
Likewise, the complaint fails to plead facts suggesting that the subsidiary
directors were less than diligent or misunderstood their roles. A wholly-owned
subsidiary is to be operated for the benefit of its parent. A subsidiary board is
entitled to support a parent’s business strategy unless it believes pursuit of that
strategy will cause the subsidiary to violate its legal obligations. Nor does a
subsidiary board have to replicate the deliberative process of its parent’s board
when taking action in aid of its parent’s acquisition strategies. [Slip opinion at 5]
The plaintiff’s complaints against the failed insurance company’s accountants, actuaries
and lawyers for aiding and abetting a fiduciary duty breach and for malpractice were also
summarily dismissed:
At bottom, the complaint simply alleges that big-dog advisors were on the
scene when Trenwick acquired Chartwell and LaSalle, that Trenwick ultimately
failed, and that in the post-Enron era, big-dog advisors should pay when things go
wrong with their clients, even when a plaintiff cannot articulate what it is that the
advisors did that was intentionally wrongful or even negligent.
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Each of the defendant advisors has moved to dismiss the complaint against
it on various grounds. I grant those motions for reasons that will be stated tersely.
First, because the complaint fails to state a claim for breach of fiduciary
duty against the Trenwick [the parent] or Trenwick America [a wholly owned
subsidiary that held principally U.S. based insurance subsidiaries] directors, the
claims that the defendant advisors aided and abetted any underlying breach of
fiduciary duty fails. As important, a claim for aiding and abetting involves the
element that the aider and abettor have “knowingly participated” in the underlying
breach of fiduciary duty. The complaint is devoid of facts suggesting that any of
the defendant advisors had any reason to believe they were assisting in a breach of
fiduciary duty against Trenwick America, a wholly-owned subsidiary of
Trenwick, by acting in the capacities they did for Trenwick, in particular in
connection with non-self dealing mergers involving Trenwick’s acquisition of
other public companies.
Second, for identical reasons, the count in the complaint purporting to
state a claim for “conspiracy to breach fiduciary duties” is equally defective.
***
Next, the malpractice claims fail to plead facts supporting an inference
that the defendant advisors breached the standard of professional care owed by
them. For example, as to defendant Milliman, an actuarial firm, the complaint
simply states that Milliman’s estimate that Chartwell’s reserves at the time of its
acquisition would be sufficient, when supplemented with $100 million in
additional coverage, was wrong. The inflammatory allegations that Milliman must
have known they were wrong or manipulated its certification are entirely
conclusory and are not accompanied by factual context giving rise to the odor of
purposeful wrongdoing or professional slack. Notably, the Litigation Trust has not
pled that Milliman warranted that if its estimates were wrong, it would be strictly
liable. Indeed, to the contrary, the public documents the complaint draws upon
contain heavy caveats regarding these estimates. In addition, as the Second
Circuit recognized, regardless of the actuarial method used, calculations of net
worth for casualty risk reinsurers are not as firmly determinable as other financial
line items.198
The Trenwick decision follows the Third Circuit decision In re CITX Corp. Inc.,199 which
held that only fraudulent conduct would suffice to support a deepening insolvency claim and
declined to allow a claim alleging that negligent conduct caused a deepening insolvency. The
Third Circuit also held that deepening insolvency was not a valid theory of damages supporting a
professional malpractice claim against an accounting firm.
198
199
Citing Delta Holdings, Inc. v. Nat’l Distillers & Chem. Corp., 945 F.2d 1226, 1231 (2d Cir. 1991) [Slip opinion at 8184].
448 F.3d 672 (3d Cir. 2006).
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In North American Catholic Educational Programming Foundation Inc. v. Gheewalla,200
the Delaware Supreme Court held “that the creditors of a Delaware corporation that is either
insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for
breach of fiduciary duty against the corporation’s directors.” [fn. Slip opinion at 4]. The Supreme
Court elaborated on this holding as follows:
It is well established that the directors owe their fiduciary obligations to
the corporation and its shareholders. While shareholders rely on directors acting
as fiduciaries to protect their interests, creditors are afforded protection through
contractual agreements, fraud and fraudulent conveyance law, implied covenants
of good faith and fair dealing, bankruptcy law, general commercial law and other
sources of creditor rights. Delaware courts have traditionally been reluctant to
expand existing fiduciary duties. Accordingly, “the general rule is that directors
do not owe creditors duties beyond the relevant contractual terms.”
***
In this case, the need for providing directors with definitive guidance
compels us to hold that no direct claim for breach of fiduciary duties may be
asserted by the creditors of a solvent corporation that is operating in the zone of
insolvency. When a solvent corporation is navigating in the zone of insolvency,
the focus for Delaware directors does not change: directors must continue to
discharge their fiduciary duties to the corporation and its shareholders by
exercising their business judgment in the best interests of the corporation for the
benefit of its shareholder owners. Therefore, we hold the Court of Chancery
properly concluded that Count II of the NACEPF Complaint fails to state a claim,
as a matter of Delaware law, to the extent that it attempts to assert a direct claim
for breach of fiduciary duty to a creditor while Clearwire was operating in the
zone of insolvency.
***
It is well settled that directors owe fiduciary duties to the corporation.
When a corporation is solvent, those duties may be enforced by its shareholders,
who have standing to bring derivative actions on behalf of the corporation
because they are the ultimate beneficiaries of the corporation’s growth and
increased value. When a corporation is insolvent, however, its creditors take the
place of the shareholders as the residual beneficiaries of any increase in value.
Consequently, the creditors of an insolvent corporation have standing to maintain
derivative claims against directors on behalf of the corporation for breaches of
fiduciary duties. The corporation’s insolvency “makes the creditors the principal
constituency injured by any fiduciary breaches that diminish the firm’s value.”
Therefore, equitable considerations give creditors standing to pursue derivative
claims against the directors of an insolvent corporation. Individual creditors of an
200
930 A2d 92, 2007 WL 1453705 (Del. 2007).
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insolvent corporation have the same incentive to pursue valid derivative claims on
its behalf that shareholders have when the corporation is solvent.
***
Recognizing that directors of an insolvent corporation owe direct fiduciary
duties to creditors, would create uncertainty for directors who have a fiduciary
duty to exercise their business judgment in the best interest of the insolvent
corporation. To recognize a new right for creditors to bring direct fiduciary claims
against those directors would create a conflict between those directors’ duty to
maximize the value of the insolvent corporation for the benefit of all those having
an interest in it, and the newly recognized direct fiduciary duty to individual
creditors. Directors of insolvent corporations must retain the freedom to engage in
vigorous, good faith negotiations with individual creditors for the benefit of the
corporation. Accordingly, we hold that individual creditors of an insolvent
corporation have no right to assert direct claims for breach of fiduciary duty
against corporate directors. Creditors may nonetheless protect their interest by
bringing derivative claims on behalf of the insolvent corporation or any other
direct nonfiduciary claim, as discussed earlier in this opinion, that may be
available for individual creditors.
E.
Conflicts of Interest.
Conflicts of interest are usually present in closely held corporations where the
shareholders are also directors and officers. While the Texas Corporate Statues allow
transactions with interested parties after disclosure and disinterested director or shareholder
approval,201 when insolvency arises, the conflict of interest rules change.
After insolvency, Texas directors begin to owe a fiduciary duty to the creditors and
cannot rely on the business judgment rule or disclosure to the disinterested directors as a
defense.202 Instead, the disclosure must include the creditors.203
After insolvency, Delaware law dictates a similar result.204 The Delaware duty of
fairness on transactions with interested parties runs to the creditors when the corporation is
insolvent.205
A developing issue involves the application of the conflict of interest rules to parties that
are related to the director or officer. While the courts are not uniform in their definition, the
conflict of interest rules usually extend to family members.
201
202
203
204
205
See discussion of TBOC § 21.418 and TBCA art. 2.35-1 in notes 157-163 and related text, supra.
Weaver v. Kellog, 216 B.R. 563 (S.D. Tex. 1997).
Id.
Kahn v. Lynch Communications Systems, Inc., 638 A.2d 1110, 1115 (Del. 1994).
Id.
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F.
Fraudulent Transfers.
Both state and federal law prohibit fraudulent transfers.206 All require insolvency at the
time of the transaction. The Texas and Delaware fraudulent transfer statutes are identical to the
Uniform Fraudulent Transfer Act, except Delaware adds the following provision: “Unless
displaced by the provisions of this chapter, the principles of law and equity, including the law
merchant and the law relating to principal and agent, estoppel, laches, fraud, misrepresentation,
duress, coercion, mistake, insolvency or other validating or invalidating cause, supplement its
provisions.”207
The applicable statute of limitation varies with the circumstances and the applicable law.
Generally, the statute of limitations for state laws may extend to four years, while bankruptcy
law dictates a one year limitation starting with the petition filing date.
IV.
Executive Compensation Process.
A.
Fiduciary Duties.
Decisions regarding the compensation of management are among the most important and
controversial decisions that a Board can make.208 The shareholders and management both want
management to be compensated sufficiently so they feel amply rewarded for their efforts in
making the entity a profitable investment for the shareholders, are motivated to work hard for the
success of the entity, and are able to attract and retain other talented executives. Executives are
naturally concerned that they be fully rewarded and provided significant incentives. The
shareholders, however, are also mindful that amounts paid to management reduce the profits
available for the shareholders, want pay to be linked to performance, and may challenge
compensation that they deem excessive in the media, in elections of directors and in the courts.
As the situation is fraught with potential conflicts, Boards often delegate the power and
responsibility for setting executive compensation to a committee of directors (a “compensation
committee”), typically composed of independent directors.209 The objective is to follow a
process that will resolve the inherent conflicts of interest, comply with the requirements of SOX
and other applicable laws,210 and satisfy the fiduciary duties of all involved.
The fiduciary duties discussed elsewhere herein, including the duties of care, loyalty and
disclosure, are all applicable when directors consider executive compensation matters.211 As in
other contexts, process and disinterested judgment are critical.
206
207
208
209
210
211
TEX. BUS. & COM. CODE CHAP. 24; DEL. CODE ANN. tit. 6, § 1301 et seq.; 11 U.S.C. § 548.
DEL. CODE ANN. tit. 6, § 1310.
See Bruce F. Dravis, The Role of Independent Directors after Sarbanes-Oxley 79 (2007).
See Bruce F. Dravis, The Role of Independent Directors after Sarbanes-Oxley 79-82 (2007); see also notes 131-145
and related text, supra.
See notes 121-163 and related text, supra, and notes 212-247 and related text, infra.
See notes 21-94, notes 131-154, and related text, supra.
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B.
Specific Cases.
1.
Walt Disney.
In respect of directors’ fiduciary duties in approving executive compensation, the
Delaware Supreme Court’s opinion dated June 8, 2006, in In re The Walt Disney Co. Derivative
Litigation,212 which resulted from the failed marriage between Disney and its former President
Michael Ovitz, and the Chancery Court decisions which preceded it are instructive. The Supreme
Court affirmed the Court of Chancery’s determination after a 37-day trial213 that Disney’s
directors had not breached their fiduciary duties in connection with the hiring or termination of
Michael Ovitz as President of The Walt Disney Company. In so ruling, the Supreme Court
clarified the parameters of the obligation of corporate fiduciaries to act in good faith and offered
helpful guidance about the types of conduct that constitute “bad faith.”
a.
Facts.
The facts surrounding the Disney saga involved a derivative suit against Disney’s
directors and officers for damages allegedly arising out of the 1995 hiring and the 1996 firing of
Michael Ovitz. The termination resulted in a non-fault termination payment to Ovitz under the
terms of his employment agreement valued at roughly $140 million (including the value of stock
options). The shareholder plaintiffs alleged that the Disney directors had breached their
fiduciary duties both in approving Ovitz’s employment agreement and in later allowing the
payment of the non-fault termination benefits.
b.
May 28, 2003 Chancery Court Opinion.
In a May 28, 2003 opinion,214 the Chancery Court denied the defendants’ motions to
dismiss an amended complaint alleging that Disney directors breached their fiduciary duties
when they approved a lucrative pay package, including a $40 million no-fault termination award
and stock options, to Ovitz. “It is rare when a court imposes liability on directors of a
corporation for breach of the duty of care,” Chancellor Chandler said. However, the allegations
in the new complaint “do not implicate merely negligent or grossly negligent decision making by
corporate directors. Quite the contrary; plaintiffs’ new complaint suggests that the Disney
directors failed to exercise any business judgment and failed to make any good faith attempt to
fulfill their fiduciary duties to Disney and its stockholders.”
c.
September 10, 2004 Chancery Court Opinion (Ovitz’ Fiduciary Duties
Regarding His Employment Agreement).
On September 10, 2004, the Chancery Court ruled on defendant Ovitz’ motion for
summary judgment215 as follows: (i) as to claims based on Ovitz entering into his employment
agreement with Disney, the Court granted summary judgment for Ovitz confirming that “before
becoming a fiduciary, Ovitz had the right to seek the best employment agreement possible for
212
213
214
215
906 A.2d 27 (Del. 2006).
907 A.2d 693 (Del. Ch. 2005).
825 A.2d 275 (Del. Ch. 2003).
2004 WL 2050138 (Del. Ch. 2004).
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himself and endorsing a bright line rule that officers and directors become fiduciaries only when
they are officially installed, and receive the formal investiture of authority that accompanies such
office or directorship . . .”; and (ii) as to claims based on actions after he became an officer, (a)
“an officer may negotiate his or her own employment agreement as long as the process involves
negotiations performed in an adversarial and arms-length manner”; (b) “Ovitz made the decision
that a faithful fiduciary would make by abstaining from attendance at a [Compensation
Committee] meeting [of which he was an ex officio member] where a substantial part of his own
compensation was to be discussed and decided upon”; (c) Ovitz did not breach any fiduciary
duties by executing and performing his employment agreement after he became an officer since
no material change was made in it from the form negotiated and approved prior to his becoming
an officer; (d) in negotiating his no fault termination, his conduct should be measured under
DGCL §144 [interested transactions not void if approved by disinterested board or shareholders
after full disclosure]; but (e) since his termination involved some negotiation for additional
benefits, there was a fact question as to whether he improperly colluded with other side of table
in the negotiations and “whether a majority of any disinterested group of independent directors
ever authorized the payment of Ovitz severance payments . . . . Absent a demonstration that the
transaction was fair to Disney, the transaction may be voidable at the discretion of the company.”
d.
August 9, 2005 Chancery Court Post Trial Opinion.
On August 9, 2005, the Chancery Court rendered an opinion216 after a 37-day trial on the
merits in this Disney case in which he concluded that the defendant directors did not breach their
fiduciary duties or commit waste in connection with the hiring and termination of Michael Ovitz.
The opinion commented that the Court was charged with the task of determining whether
directors have breached their fiduciary duties, and not whether directors have acted in
accordance with the best practices of ideal corporate governance, and distinguished between the
role of the Court to provide a remedy for breaches of fiduciary duty and the role of the market to
provide a remedy for bad business decisions, the Court reasoned as follows:
[T]here are many aspects of defendants’ conduct that fell significantly
short of the best practices of ideal corporate governance. Recognizing the protean
nature of ideal corporate governance practices, particularly over an era that has
included the Enron and WorldCom debacles, and the resulting legislative focus on
corporate governance, it is perhaps worth pointing out that the actions (and the
failures to act) of the Disney board that gave rise to this lawsuit took place ten
years ago, and that applying 21st century notions of best practices in analyzing
whether those decisions were actionable would be misplaced.
Unlike ideals of corporate governance, a fiduciary’s duties do not change
over time. How we understand those duties may evolve and become refined, but
the duties themselves have not changed, except to the extent that fulfilling a
fiduciary duty requires obedience to other positive law. This Court strongly
encourages directors and officers to employ best practices, as those practices are
understood at the time a corporate decision is taken. But Delaware law does
not—indeed, the common law cannot—hold fiduciaries liable for a failure to
216
907 A.2d 693 (Del. Ch. 2005).
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comply with the aspirational ideal of best practices, any more than a common-law
court deciding a medical malpractice dispute can impose a standard of liability
based on ideal—rather than competent or standard—medical treatment practices,
lest the average medical practitioner be found inevitably derelict.
Fiduciaries are held by the common law to a high standard in fulfilling
their stewardship over the assets of others, a standard that (depending on the
circumstances) may not be the same as that contemplated by ideal corporate
governance. Yet therein lies perhaps the greatest strength of Delaware’s
corporation law. Fiduciaries who act faithfully and honestly on behalf of those
whose interests they represent are indeed granted wide latitude in their efforts to
maximize shareholders’ investment. Times may change, but fiduciary duties do
not. Indeed, other institutions may develop, pronounce and urge adherence to
ideals of corporate best practices. But the development of aspirational ideals,
however worthy as goals for human behavior, should not work to distort the legal
requirements by which human behavior is actually measured. Nor should the
common law of fiduciary duties become a prisoner of narrow definitions or
formulaic expressions. It is thus both the province and special duty of this Court
to measure, in light of all the facts and circumstances of a particular case, whether
an individual who has accepted a position of responsibility over the assets of
another has been unremittingly faithful to his or her charge.
Because this matter, by its very nature, has become something of a public
spectacle—commencing as it did with the spectacular hiring of one of the
entertainment industry’s best-known personalities to help run one of its iconic
businesses, and ending with a spectacular failure of that union, with breathtaking
amounts of severance pay the consequence—it is, I think, worth noting what the
role of this Court must be in evaluating decision-makers’ performance with
respect to decisions gone awry, spectacularly or otherwise. It is easy, of course,
to fault a decision that ends in a failure, once hindsight makes the result of that
decision plain to see. But the essence of business is risk—the application of
informed belief to contingencies whose outcomes can sometimes be predicted, but
never known. The decision-makers entrusted by shareholders must act out of
loyalty to those shareholders. They must in good faith act to make informed
decisions on behalf of the shareholders, untainted by self-interest. Where they fail
to do so, this Court stands ready to remedy breaches of fiduciary duty.
Even where decision-makers act as faithful servants, however, their ability
and the wisdom of their judgments will vary. The redress for failures that arise
from faithful management must come from the markets, through the action of
shareholders and the free flow of capital, and not from this Court. Should the
Court apportion liability based on the ultimate outcome of decisions taken in good
faith by faithful directors or officers, those decision-makers would necessarily
take decisions that minimize risk, not maximize value. The entire advantage of
the risk-taking, innovative, wealth-creating engine that is the Delaware
corporation would cease to exist, with disastrous results for shareholders and
society alike. That is why, under our corporate law, corporate decision-makers
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are held strictly to their fiduciary abilities, but within the boundaries of those
duties are free to act as their judgment and duties dictate, free of post hoc
penalties from a reviewing court using perfect hindsight. Corporate decisions are
made, risks are taken, the results become apparent, capital flows accordingly, and
shareholder value is increased.
On the issue of good faith, the Court suggested that the concept of good faith is not an
independent duty, but a concept inherent in a fiduciary’s duties of due care and loyalty:
Decisions from the Delaware Supreme Court and the Court of Chancery
are far from clear with respect to whether there is a separate fiduciary duty of
good faith. Good faith has been said to require an “honesty of purpose,” and a
genuine care for the fiduciary’s constituents, but, at least in the corporate
fiduciary context, it is probably easier to define bad faith rather than good faith.
This may be so because Delaware law presumes that directors act in good faith
when making business judgments. Bad faith has been defined as authorizing a
transaction “for some purpose other than a genuine attempt to advance corporate
welfare or [when the transaction] is known to constitute a violation of applicable
positive law.” In other words, an action taken with the intent to harm the
corporation is a disloyal act in bad faith. * * * It makes no difference the reason
why the director intentionally fails to pursue the best interests of the corporation.
***
Upon long and careful consideration, I am of the opinion that the concept
of intentional dereliction of duty, a conscious disregard for one’s responsibilities,
is an appropriate (although not the only) standard for determining whether
fiduciaries have acted in good faith. Deliberate indifference and inaction in the
face of a duty to act is, in my mind, conduct that is clearly disloyal to the
corporation. It is the epitome of faithless conduct.
***
e.
June 8, 2006 Supreme Court Opinion.
The Delaware Supreme Court affirmed the Court of Chancery’s conclusion that the
shareholder plaintiffs had failed to prove that the defendants had breached any fiduciary duty.217
With respect to the hiring of Ovitz and the approval of his employment agreement, the Supreme
Court held that the Court of Chancery had a sufficient evidentiary basis from which to conclude,
and had properly concluded, that the defendants had not breached their fiduciary duty of care and
had not acted in bad faith. As to the ensuing no-fault termination of Ovitz and the resulting
termination payment pursuant to his employment agreement, the Supreme Court affirmed the
Chancery Court’s holdings that the full board did not (and was not required to) approve Ovitz’s
termination, that Michael Eisner, Disney’s CEO, had authorized the termination, and that neither
217
906 A.2d 27 (Del. 2006). The Supreme Court wrote: “We conclude … that the Chancellor’s factual findings and legal
rulings were correct and not erroneous in any respect.”
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Eisner, nor Sanford Litvack, Disney’s General Counsel, had breached his duty of care or acted in
bad faith in connection with the termination.
In its opinion, the Supreme Court acknowledged that the contours of the duty of good
faith remained “relatively uncharted” and were not well developed. Mindful of the considerable
debate that the Court of Chancery’s prior opinions in the Disney litigation had generated and the
increased recognition of the importance of the duty of good faith in the current corporate law
environment, the Supreme Court determined that “some conceptual guidance to the corporate
community [about the nature of good faith] may be helpful” and provided the following color as
to the meaning of “good faith” in Delaware fiduciary duty jurisprudence:
The precise question is whether the Chancellor’s articulated standard for
bad faith corporate fiduciary conduct—intentional dereliction of duty, a conscious
disregard for one’s responsibilities—is legally correct. In approaching that
question, we note that the Chancellor characterized that definition as “an
appropriate (although not the only) standard for determining whether fiduciaries
have acted in good faith.” That observation is accurate and helpful, because as a
matter of simple logic, at least three different categories of fiduciary behavior are
candidates for the “bad faith” pejorative label.
The first category involves so-called “subjective bad faith,” that is,
fiduciary conduct motivated by an actual intent to do harm. That such conduct
constitutes classic, quintessential bad faith is a proposition so well accepted in the
liturgy of fiduciary law that it borders on axiomatic. We need not dwell further
on this category, because no such conduct is claimed to have occurred, or did
occur, in this case.
The second category of conduct, which is at the opposite end of the
spectrum, involves lack of due care—that is, fiduciary action taken solely by
reason of gross negligence and without any malevolent intent. In this case,
appellants assert claims of gross negligence to establish breaches not only of
director due care but also of the directors’ duty to act in good faith. Although the
Chancellor found, and we agree, that the appellants failed to establish gross
negligence, to afford guidance we address the issue of whether gross negligence
(including a failure to inform one’s self of available material facts), without more,
can also constitute bad faith. The answer is clearly no.
From a broad philosophical standpoint, that question is more complex than
would appear, if only because (as the Chancellor and others have observed)
“issues of good faith are (to a certain degree) inseparably and necessarily
intertwined with the duties of care and loyalty….” But, in the pragmatic,
conduct-regulating legal realm which calls for more precise conceptual line
drawing, the answer is that grossly negligent conduct, without more, does not and
cannot constitute a breach of the fiduciary duty to act in good faith. The conduct
that is the subject of due care may overlap with the conduct that comes within the
rubric of good faith in a psychological sense, but from a legal standpoint those
duties are and must remain quite distinct. Both our legislative history and our
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common law jurisprudence distinguish sharply between the duties to exercise due
care and to act in good faith, and highly significant consequences flow from that
distinction.
The Delaware General Assembly has addressed the distinction between
bad faith and a failure to exercise due care (i.e., gross negligence) in two separate
contexts. The first is Section 102(b)(7) of the DGCL, which authorizes Delaware
corporations, by a provision in the certificate of incorporation, to exculpate their
directors from monetary damage liability for a breach of the duty of care. That
exculpatory provision affords significant protection to directors of Delaware
corporations. The statute carves out several exceptions, however, including most
relevantly, “for acts or omissions not in good faith….” Thus, a corporation can
exculpate its directors from monetary liability for a breach of the duty of care, but
not for conduct that is not in good faith. To adopt a definition of bad faith that
would cause a violation of the duty of care automatically to become an act or
omission “not in good faith,” would eviscerate the protections accorded to
directors by the General Assembly’s adoption of Section 102(b)(7).
A second legislative recognition of the distinction between fiduciary
conduct that is grossly negligent and conduct that is not in good faith, is
Delaware’s indemnification statute, found at 8 Del. C. § 145. To oversimplify,
subsections (a) and (b) of that statute permit a corporation to indemnify (inter
alia) any person who is or was a director, officer, employee or agent of the
corporation against expenses (including attorneys’ fees), judgments, fines and
amounts paid in settlement of specified actions, suits or proceedings, where
(among other things): (i) that person is, was, or is threatened to be made a party to
that action, suit or proceeding, and (ii) that person “acted in good faith and in a
manner the person reasonably believed to be in or not opposed to the best interests
of the corporation….” Thus, under Delaware statutory law a director or officer of
a corporation can be indemnified for liability (and litigation expenses) incurred by
reason of a violation of the duty of care, but not for a violation of the duty to act
in good faith.
Section 145, like Section 102(b)(7), evidences the intent of the Delaware
General Assembly to afford significant protections to directors (and, in the case of
Section 145, other fiduciaries) of Delaware corporations. To adopt a definition
that conflates the duty of care with the duty to act in good faith by making a
violation of the former an automatic violation of the latter, would nullify those
legislative protections and defeat the General Assembly’s intent. There is no
basis in policy, precedent or common sense that would justify dismantling the
distinction between gross negligence and bad faith.
That leaves the third category of fiduciary conduct, which falls in between
the first two categories of (1) conduct motivated by subjective bad intent and (2)
conduct resulting from gross negligence. This third category is what the
Chancellor’s definition of bad faith—intentional dereliction of duty, a conscious
disregard for one’s responsibilities—is intended to capture. The question is
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whether such misconduct is properly treated as a non-exculpable, nonindemnifiable violation of the fiduciary duty to act in good faith. In our view it
must be, for at least two reasons.
First, the universe of fiduciary misconduct is not limited to either
disloyalty in the classic sense (i.e., preferring the adverse self-interest of the
fiduciary or of a related person to the interest of the corporation) or gross
negligence. Cases have arisen where corporate directors have no conflicting selfinterest in a decision, yet engage in misconduct that is more culpable than simple
inattention or failure to be informed of all facts material to the decision. To
protect the interests of the corporation and its shareholders, fiduciary conduct of
this kind, which does not involve disloyalty (as traditionally defined) but is
qualitatively more culpable than gross negligence, should be proscribed. A
vehicle is needed to address such violations doctrinally, and that doctrinal vehicle
is the duty to act in good faith. The Chancellor implicitly so recognized in his
Opinion, where he identified different examples of bad faith as follows:
The good faith required of a corporate fiduciary includes not
simply the duties of care and loyalty, in the narrow sense that I
have discussed them above, but all actions required by a true
faithfulness and devotion to the interests of the corporation and its
shareholders. A failure to act in good faith may be shown, for
instance, where the fiduciary intentionally acts with a purpose
other than that of advancing the best interests of the corporation,
where the fiduciary acts with the intent to violate applicable
positive law, or where the fiduciary intentionally fails to act in the
face of a known duty to act, demonstrating a conscious disregard
for his duties. There may be other examples of bad faith yet to be
proven or alleged, but these three are the most salient.
Those articulated examples of bad faith are not new to our jurisprudence. Indeed,
they echo pronouncements our courts have made throughout the decades.
Second, the legislature has also recognized this intermediate category of
fiduciary misconduct, which ranks between conduct involving subjective bad faith
and gross negligence. Section 102(b)(7)(ii) of the DGCL expressly denies money
damage exculpation for “acts or omissions not in good faith or which involve
intentional misconduct or a knowing violation of law.” By its very terms that
provision distinguishes between “intentional misconduct” and a “knowing
violation of law” (both examples of subjective bad faith) on the one hand, and
“acts…not in good faith,” on the other. Because the statute exculpates directors
only for conduct amounting to gross negligence, the statutory denial of
exculpation for “acts…not in good faith” must encompass the intermediate
category of misconduct captured by the Chancellor’s definition of bad faith.
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For these reasons, we uphold the Court of Chancery’s definition as a
legally appropriate, although not the exclusive, definition of fiduciary bad faith.
We need go no further.
In addition to the helpful discussion about the contours of the duty of good faith, the
Supreme Court’s opinion offers guidance on several other issues. For example, the Supreme
Court affirmed the Chancellor’s rulings relating to the power of Michael Eisner, as Disney’s
CEO, to terminate Mr. Ovitz as President. The Supreme Court also adopted the same practical
view as the Court of Chancery regarding the important statutory protections offered by DGCL
§ 141(e), which permits corporate directors to rely in good faith on information provided by
fellow directors, board committees, officers, and outside consultants.
The Court also found plaintiffs had “not come close to satisfying the high hurdle required
to establish waste” as the Board’s approval of Ovitz’s employment agreement “had a rational
business purpose: to induce Ovitz to leave [his prior position], at what would otherwise be a
considerable cost to him, in order to join Disney.”
2.
Integrated Health.
The May 28, 2003 Chancery Court decision on the motion to dismiss in Disney
influenced the denial of a motion to dismiss many of the allegations that a corporation’s board
breached its fiduciary duties in connection with an extensive and multifaceted compensation
package benefiting its founder and CEO in Official Committee of Unsecured Creditors of
Integrated Health Services, Inc. v. Elkins.218 Integrated Health had been founded by the CEO in
the mid-1980s to operate a national chain of nursing homes and to provide care to patients
typically following discharge from hospitals, and prospered and grew substantially. Radical
changes in Medicare reimbursement in 1997 led to Integrated Health’s decline and
commencement of Chapter 11 Bankruptcy Code proceedings in February 2000. After the
Bankruptcy Court abstained from adjudicating fiduciary claims against the CEO and directors,
plaintiff brought suit in the Delaware Chancery Court, alleging that CEO breached his fiduciary
duties of loyalty and good faith to the corporation by improperly obtaining certain compensation
arrangements. The plaintiff also alleged that the directors (other than the CEO) breached their
duties of loyalty and good faith by (1) subordinating the best interests of Integrated Health to
their allegiance to the CEO, by failing to exercise independent judgment with respect to certain
compensation arrangements, (2) failing to select and rely on an independent compensation
consultant to address the CEO’s compensation arrangements, and (3) participating in the CEO’s
breaches of fiduciary duty by approving or ratifying his actions. The plaintiff also alleged that
each of the defendant directors breached his fiduciary duty of care by (i) approving or ratifying
compensation arrangements without adequate information, consideration or deliberation, (ii)
failing to exercise reasonable care in selecting and overseeing the compensation expert, and (iii)
failing to monitor how the proceeds of loans to the CEO were utilized by him. These actions
were alleged to have constituted waste.
In Integrated Health, the defendants attempted to defend the breach of loyalty claims by
arguing that a Board consisting of a majority of disinterested, independent directors had
218
2004 WL 1949290 (Del. Ch. Aug. 24, 2004).
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approved all compensation arrangements. Addressing first the question of whether a majority of
the members of the Board were “interested” in the challenged transactions or were “beholden” to
one who was interested in the challenged transactions, the Chancery Court noted the distinction
between “interest,” which requires that a person receive a personal financial benefit from a
transaction that is not equally shared by stockholders, and “independence,” which requires the
pleading of facts that raise sufficient doubt that a director’s decision was based on extraneous
considerations or influences rather than on the corporate merits of the transaction. The Chancery
Court wrote that this inquiry was fact specific (requiring the application of a subjective “actual
person” standard, rather than an objective “reasonable director” standard) and that it would not
deem a director to lack independence unless the plaintiff alleged, in addition to someone’s
control over a company, facts that would demonstrate that through personal or other relationships
the directors were beholden to the controlling person. The Chancery Court concluded that under
Delaware law (i) personal friendships, without more, (ii) outside business relationships, without
more, and (iii) approving or acquiescing in a challenged transaction, in each case without more,
were insufficient to raise a reasonable doubt of a directors’ ability to exercise independent
business judgment. The court stated that while domination and control are not tested merely by
economics, the plaintiff must allege some facts showing a director is “beholden” to an interested
director in order to show a lack of independence. The critical issue was whether the director was
conflicted in his loyalties with respect to the challenged board action. The Chancery Court found
that the directors were not interested in the CEO’s compensation transactions and found that
most of the directors were not beholden to the CEO. Focusing specifically on a lawyer who was
a founding partner of a law firm that provided legal services to the corporation, the court said
such facts, without more, were not enough to establish that the lawyer was beholden to the CEO.
One director who had been an officer of a subsidiary during part of the time period involved was
assumed to have lacked independence from the CEO, but there were enough other directors who
were found not to be interested and found to be independent so that all the transactions were
approved by a board consisting of a majority of independent, disinterested directors.
The defendants responded to the plaintiff’s duty of care claims with three separate
arguments: (i) to the extent the defendants relied on the compensation expert’s opinions in
approving the challenged transaction, they were insulated from liability by DGCL § 141(e),
which permits good faith reliance on experts; (ii) to the extent DGCL § 141(e) did not insulate
the defendants from liability, Integrated Health’s DGCL § 102(b)(7) exculpation provision did
so; and (iii) regardless of the DGCL § 141(e) and DGCL § 102(b)(7) defenses, plaintiff had
failed to plead facts that showed gross negligence, which the defendants said was a necessary
minimum foundation for a due care claim.
The Chancery Court declined to dismiss the bad faith and breach of loyalty claims
against the CEO himself, adopting the May 28, 2003 Disney standard that once an employee
becomes a fiduciary of an entity, he had a duty to negotiate further compensation arrangements
“honestly and in good faith so as not to advantage himself at the expense of the [entity’s]
shareholders,” but that such requirement did not prevent fiduciaries from negotiating their own
employment agreements so long as such negotiations were “performed in an adversarial and
arms-length manner.”
As to whether any of the challenged transactions was authorized with the kind of
intentional or conscious disregard that avoided the DGCL § 102(b)(7) exculpatory provision
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defense, the court wrote that in the May 28, 2003 Disney decision the Chancellor determined that
the complaint adequately alleged that the defendants consciously and intentionally disregarded
their responsibilities, and wrote that while there may be instances in which a board may act with
deference to corporate officers’ judgments, executive compensation was not one of those
instances: “The board must exercise its own business judgment in approving an executive
compensation transaction.”219 Since the case involved a motion to dismiss based on the DGCL
§ 102(b)(7) provision in the corporation’s certificate of incorporation, the plaintiff must plead
facts that, if true, would show that the board consciously and intentionally disregarded its
responsibilities (as contrasted with being only grossly negligent). Examining each of the specific
compensation pieces attacked in the pleadings, the court found that the following alleged facts
met such conscious and intentional standard: (i) loans from the corporation to the CEO that were
initiated by the CEO were approved by the compensation committee and the board only after the
loans had been made; (ii) the compensation committee gave approval to loans even though it was
given no explanation as to why the loans were made; (iii) the Board, without additional
investigation deliberation, consultation with an expert or determination as to what the
compensation committee’s decision process was, ratified loans (loan proceeds were received
prior to approval of loans by the compensation committee); (iv) loan forgiveness provisions were
extended by unanimous written consent without any deliberation or advice from any expert; (v)
loans were extended without deliberation as to whether the corporation received any
consideration for the loans; and (vi) there were no identified corporate authorizations or analysis
of the costs to the corporation or the corporate reason therefor performed either by the
compensation committee or other members of the Board with respect to the provisions in CEO’s
employment contract that gave him large compensation if he departed from the company.
Distinguishing between the alleged total lack of deliberation discussed in the May 28,
2003 Disney opinion and the alleged inadequate deliberation in Integrated Health, the Chancery
Court wrote:
Thus a change in characterization from a total lack of deliberation (and for that
matter a difference between the meaning of discussion and deliberation, if there is
one), to even a short conversation may change the outcome of a Disney analysis.
Allegations of non-deliberation are different from allegations of not enough
deliberation.220
Later in the opinion, in granting a motion to dismiss with respect to some of the compensation
claims, the Chancery Court suggested that arguments as to what would be a reasonable length of
time for board discussion or what would be an unreasonable length of time for the Board to
consider certain decisions were not particularly helpful in evaluation a fiduciary duty claim:
As long as the Board engaged in action that can lead the Court to conclude it did
not act in knowing and deliberate indifference to its fiduciary duties, the inquiry
219
220
Id. at *12.
Id. at *13 fn. 58.
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of this nature ends. The Court does not look at the reasonableness of a Board’s
actions in this context, as long as the Board exercised some business judgment.221
In the end, the Chancery Court upheld claims alleging that no deliberation occurred concerning
certain elements of compensation to Elkins, but dismissed claims alleging that some (but
inadequate) deliberation occurred. Further, the decision upheld claims alleging a failure to
consult with a compensation expert as to some elements of compensation, but dismissed claims
alleging that the directors consulted for too short a period of time with the compensation expert
who had been chosen by the CEO and whose work had been reviewed by the CEO in at least
some instances prior to being presented to directors. Thus, it appears that directors who give
some attention to an issue, as opposed to none, will have a better argument that they did not
consciously and intentionally disregard their responsibilities.
3.
Sample v. Morgan.
In Sample v. Morgan,222 the plaintiff alleged a variety of breaches of director fiduciary
duties, including the duties of disclosure and loyalty, in connection with the Board’s action in
seeking approval from the company’s stockholders for a certificate of incorporation amendment
(the “Charter Amendment”) and a Management Stock Incentive Plan (the “Incentive Plan”) that
reduced the par value of the company stock from a dollar per share to a tenth of a cent each and
authorized a 200,000 share (46%) increase in the number of shares for the purpose of “attracting
and retaining” key employees. The same day as the stockholder vote, the Board formed a
Compensation Committee, consisting of the Board’s two putatively independent directors, to
consider how to implement the Incentive Plan. At its very first meeting, which lasted only 25
minutes, the two member Compensation Committee considered a proposal by the company’s
outside counsel to grant all the newly authorized shares to just three employees of the company –
the CEO, the CFO, and the Vice President of Manufacturing – all of whom were directors of the
company and who collectively comprised the majority of the company’s five member board of
directors (the “Insider Majority”). Within ten days, the board approved a version of that
proposal at a 20 minute meeting. Although the Compensation Committee adopted a vesting
schedule for the grants that extended for some years and required the Insider Majority members
to remain with the company, all of the newly authorized shares could be voted by the Insider
Majority immediately and would receive dividends immediately. The Committee only required
the Insider Majority to pay a tenth of a penny per share. Soon thereafter, the Compensation
Committee authorized the company to borrow approximately $700,000 to cover the taxes owed
by the Insider Majority on the shares they received, although the company’s net sales were less
than $10 million and it lost over $1.7 million before taxes. In determining the Insider Majority’s
tax liability, the Compensation Committee estimated the value of the shares granted to be $5.60
apiece, although the Insider Majority only paid a tenth of a penny per share to get them.
Throughout the process, the only advisor to the Compensation Committee was the company’s
outside counsel, who had structured the transactions for the Insider Majority.
221
222
Id. at *14. Vice Chancellor Noble wrote: “The Compensation Committee’s signing of unanimous written consents in
this case raises a concern as to whether it acted with knowing and deliberate indifference.”
914 A.2d 647 (Del. Ch. Jan. 23, 2007).
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When the use of the Incentive Plan shares was disclosed, plaintiff filed suit in the
Delaware Chancery Court, alleging that the grant of the new shares was a wasteful entrenchment
scheme designed to ensure that the Insider Majority would retain control of the company and that
the stockholders’ approval of the Charter Amendment and the Incentive Plan were procured
through materially misleading disclosures. The complaint noted that the directors failed to
disclose that the Charter Amendment and Incentive Plan had resulted from planning between the
company’s outside counsel – the same one who eventually served as the sole advisor to the
Compensation Committee that decided to award all of the new shares to the Insider Majority at
the cheapest possible price and with immediate voting and dividend rights – and the company’s
CEO. In memoranda to the CEO, the company’s outside counsel articulated that the Incentive
Plan was inspired by the Insider Majority’s desire to own “a significant equity stake in the
company as incentive for them to grow the company and increase stockholder value, as well as
to provide them with protection against a third party ... gaining significant voting control over the
company.” Those memoranda also contained other material information, including the fact that
the company counsel had advised the CEO that a plan constituting 46% of the then-outstanding
equity was well above the range of typical corporate equity plans.
Also not disclosed to the stockholders was the fact that the company had entered into a
contract with the buyer of the company’s largest existing bloc of shares simultaneously with the
Board’s approval of the Charter Amendment and the Incentive Plan which provided that for five
years thereafter the company would not issue any shares in excess of the new shares that were to
be issued if the Charter Amendment and Incentive Plan were approved. Thus, the stockholders
were not told that they were authorizing the issuance to management of the only equity the
company could issue for five years, nor were they told that the Board knew this when it approved
the contract, the Charter Amendment, and the Incentive Plan all at the same meeting.
In denying defendants’ motion to dismiss, Vice Chancellor Strine wrote:
The complaint plainly states a cause of action. Stockholders voting to
authorize the issuance of 200,000 shares comprising nearly a third of the
company’s voting power in order to “attract and retain key employees” would
certainly find it material to know that the CEO and company counsel who
conjured up the Incentive Plan envisioned that the entire bloc of shares would go
to the CEO and two other members of top management who were on the board. A
rational stockholder in a small company would also want to know that by voting
yes on the Charter Amendment and Incentive Plan, he was authorizing
management to receive the only shares that the company could issue during the
next five years due to a contract that the board had simultaneously signed with the
buyer of another large bloc of shares.
In view of those non-disclosures, it rather obviously follows that the brief
meetings at which the Compensation Committee, relying only the advice of the
company counsel who had helped the Insider Majority develop a strategy to
secure a large bloc that would deter takeover bids, bestowed upon the Insider
Majority all 200,000 shares do not, as a matter of law, suffice to require dismissal
of the claim that those acts resulted from a purposeful scheme of entrenchment
and were wasteful. The complaint raises serious questions about what the two
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putatively independent directors who comprised the Compensation Committee
knew about the motivation for the issuance, whether they were complicitous with
the Insider Majority and company counsel’s entrenchment plans, and whether
they were adequately informed about the implications of their actions in light of
their reliance on company counsel as their sole source of advice.
As important, the directors do not explain how subsequent action of the
board in issuing shares to the Insider Majority could cure the attainment of
stockholder approval through disclosures that were materially misleading. To that
point, the directors also fail to realize that the contractual limitation they placed
on their ability to raise other equity capital bears on the issue of whether the
complaint states a claim for relief. Requiring the Insider Majority to relinquish
their equity in order to give the company breathing room to issue other equity
capital without violating the contract is a plausible remedy that might be ordered
at a later stage.
Finally, although the test for waste is stringent, it would be error to
determine that the board could not, as a matter of law, have committed waste by
causing the company to go into debt in order to give a tax-free grant of nearly a
third of the company’s voting power and dividend stream to existing managers
with entrenchment motives and who comprise a majority of the board in exchange
for a tenth of a penny per share. If giving away nearly a third of the voting and
cash flow rights of a public company for $200 in order to retain managers who
ardently desired to become firmly entrenched just where they were does not raise
a pleading-stage inference of waste, it is difficult to imagine what would.
After the Court’s decision on the motion to dismiss, the plaintiff amended the complaint
to state claims for aiding and abetting breaches of fiduciary duty against the company counsel
who had structured the challenged transactions for the Insider Majority, Baker & Hostetler LLP
and a Columbus, Ohio based partner who led the representation. The law firm and partner
moved to dismiss the claims against them solely on the grounds that the Delaware court lacked
personal jurisdiction over them. In denying this motion to dismiss, the Court determined that the
non-Delaware lawyer and his non-Delaware law firm who provided advice on Delaware law to
the Delaware corporation and caused a charter amendment to be filed with the Delaware
Secretary of State are subject to personal jurisdiction in Delaware courts.223 The Court
summarized the issues as follows:
The question presented is a straightforward one. May a corporate lawyer and his
law firm be sued in Delaware as to claims arising out of their actions in providing
advice and services to a Delaware public corporation, its directors, and its
managers regarding matters of Delaware corporate law when the lawyer and law
firm: i) prepared and delivered to Delaware for filing a certificate amendment
under challenge in the lawsuit; ii) advertise themselves as being able to provide
coast-to-coast legal services and as experts in matters of corporate governance;
iii) provided legal advice on a range of Delaware law matters at issue in the
223
Sample v. Morgan, 2007 WL 4207790 (Del. Ch. Nov. 27, 2007).
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lawsuit; iv) undertook to direct the defense of the lawsuit; and v) face well-pled
allegations of having aided and abetted the top managers of the corporation in
breaching their fiduciary duties by entrenching and enriching themselves at the
expense of the corporation and its public stockholders? The answer is yes.
The Court noted that the lawyers were paid by the company, but the beneficiaries of the
entrenchment plan were the Insider Majority and the losers were the other shareholders who
suffered serious dilution and the company which had the pay the costs. In rejecting the lawyers’
arguments that neither the Delaware long-arm statute nor the U.S. Constitution permitted lawyers
who did their work outside of Delaware for a corporation headquartered outside of Delaware, the
Court wrote:
Delaware has no public policy interest in shielding corporate advisors from
responsibility for consciously assisting the managers of Delaware corporations in
breaching their fiduciary duties. If well-pled facts can be pled that support the
inference that a corporate advisor knowingly assisted corporate directors in
breaching their fiduciary duties, Delaware has a public policy interest in ensuring
that its courts are available to derivative plaintiffs who wish to hold that advisor
accountable to the corporation. The precise circumstances when corporate
advisors should be deemed responsible to the corporation or its stockholders for
their role in advising directors and officers should be determined by decisions
addressing the merits of aiding and abetting claims, not by decisions about
motions to dismiss for lack of personal jurisdiction. Lawyers and law firms, like
other defendants, can be sued in this state if there is a statutory and constitutional
foundation for doing so.
* * *
For sophisticated counsel to argue that they did not realize that acting as a de
facto outside general counsel to a Delaware corporation and regularly providing
advice about Delaware law about matters important to that corporation and its
stockholders might expose it to this Court’s jurisdiction fails the straight-face test.
The moving defendants knew that the propriety of the corporate action taken in
reliance upon its advice and through its services would be determined under
Delaware corporate law and likely in a Delaware court.
The Court acknowledged that the facts in the case were “highly unusual” and that in “most
fiduciary duty cases, it will be exceedingly difficult for plaintiffs to state an aiding and abetting
claim against corporate counsel.”
4.
Ryan v. Gifford.
Ryan v. Gifford224 was a derivative action involving options backdating, a practice that
involves the granting of options under a stock option plan approved by the issuer’s stockholders
which requires that the option exercise price not be less than the market price of the underlying
224
918 A.2d 341 (Del. Ch. Feb. 6, 2007).
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stock on the date of grant and increasing the management compensation by fixing the grant date
on an earlier date when the stock was trading for less than the market price on the date of the
corporate action required to effect the grant.225 Plaintiff alleged that defendants breached their
fiduciary duties of due care and loyalty by approving or accepting backdated options that
violated the clear terms of the stockholder approved option plans. Chancellor William B.
Chandler III denied defendants’ motion to discuss the derivative action because plaintiff failed to
first demand that the issuer commence the proceedings, ruling that because “one half of the
current board members approved each challenged transaction,” asking for board approval was
not required.226 The Chancellor also denied defendants’ motion to transfer the case to California
where other backdating cases involving Maxim are pending, or stay the Delaware proceedings
pending resolution of the California cases, basing his decision on the absence of Delaware
precedent on options backdating and the importance of there being Delaware guidance on the
issues.227
Turning to the substance of the case, the Chancellor held “that the intentional violation of
a shareholder approved stock option plan, coupled with fraudulent disclosures regarding the
directors’ purported compliance with that plan, constitute conduct that is disloyal to the
corporation and is therefore an act in bad faith.”228 The Chancellor further commented:
A director who approves the backdating of options faces at the very least a
substantial likelihood of liability, if only because it is difficult to conceive of a
context in which a director may simultaneously lie to his shareholders (regarding
his violations of a shareholder-approved plan, no less) and yet satisfy his duty of
loyalty. Backdating options qualifies as one of those “rare cases [in which] a
transaction may be so egregious on its face that board approval cannot meet the
test of business judgment, and a substantial likelihood of director liability
therefore exists.” Plaintiff alleges that three members of a board approved
backdated options, and another board member accepted them. These are
sufficient allegations to raise a reason to doubt the disinterestedness of the current
board and to suggest that they are incapable of impartially considering demand.
***
225
226
227
228
See Appendix B for a discussion of options backdating issues; see C. Stephen Bigler & Pamela H. Sudell, Delaware
Law Developments: Stock Option Backdating and Spring-Loading, 40 Rev. Sec. & Comm. Reg. 115 (May 16, 2007).
See Conrad v. Blank, C.A. No. 2611-VCL (Del. Ch. September 7, 2007) (derivative claims that 17 past and current
board members of Staples Inc. breached their fiduciary duties and committed corporate waste by authorizing or
wrongly permitting the secret backdating of stock option grants to corporate executives; the court held that demand was
excused as these “same directors” had already conducted an investigation and took no action even though company
took a $10.8 million charge in 2006 (covering 10 years), cryptically stating only that certain options had been issued
using “incorrect measuring dates”; the court explained: “after finding substantial evidence that options were, in fact,
mispriced, the company and the audit committee ended their ‘review’ without explanation and apparently without
seeking redress of any kind. In these circumstances, it would be odd if Delaware law required a stockholder to make
demand on the board of directors before suing on those very same theories of recovery.”)
See also Brandin v. Deason, 2123-VCL (Del. Ch. July 20, 2007), in which the Court denied a motion to stay a
derivative action in favor of a later-filed parallel proceeding in a Texas federal district court, citing the fact that the
proceedings had already begun in Delaware and the involvement of unsettled aspects of Delaware law as justifications
for denying the stay.
2007 WL 416162 (Del. Ch. February 6, 2007) at 11.
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I am unable to fathom a situation where the deliberate violation of a
shareholder approved stock option plan and false disclosures, obviously intended
to mislead shareholders into thinking that the directors complied honestly with the
shareholder-approved option plan, is anything but an act of bad faith. It certainly
cannot be said to amount to faithful and devoted conduct of a loyal fiduciary.
Well-pleaded allegations of such conduct are sufficient, in my opinion, to rebut
the business judgment rule and to survive a motion to dismiss.229
The Chancellor dismissed claims concerning transactions that occurred before the plaintiff
owned shares.
The Chancellor’s refusal to dismiss the suits on procedural grounds opened up the
discovery phase of the litigation, which was marked by numerous disputes concerning
jurisdiction over additional defendants and access to documents. The plaintiffs sought access to
a report prepared by an outside law firm which the Special Committee engaged as Special
Counsel to investigate the stock-option-backdating charges. The Chancellor rejected arguments
that various communications and notes between the Special Committee and its Special Counsel
were protected by the attorney-client privilege, which allows attorneys and clients to confer
confidentially, or by the work product doctrine, which protects draft versions of documents
The Court ruled that when the Special Committee
related to preparation for lawsuits.230
presented the internal investigation report to the full Board, the report and related
communications were not protected because (1) only the Special Committee was the client of
Special Counsel and not the full Board, which included the defendant CEO and CFO whose
actions were being investigated by the Special Committee, and (2) the presentation to the full
Board constituted a waiver of any privileges that would have otherwise attached.231 The
229
230
231
Id. at 9 and 11. The Chancellor’s focus on the inability of directors consistently with their fiduciary duties to grant
options that deviate from the provisions of a stockholder is consistent with the statement that “Delaware law requires
that the terms and conditions of stock options be governed by a written, board approved plan” in First Marblehead
Corp. v. House, 473 F.3d 1, 6 (1st Cir. 2006), a case arising out of a former employee attempting to exercise a stock
option more than three months after his resignation. In First Marblehead the option plan provided that no option could
be exercisable more than three months after the optionee ceased to be an employee, but the former employee was never
given a copy of the option plan nor told of this provision. The Court held that the employee’s breach of contract claim
was barred by Delaware law because it conflicted with the plan, but that under the laws of Massachusetts the issuer’s
failure to disclose this term constituted negligent misrepresentation.
Ryan v. Gifford, 2007 WL 4259557 (Del. Ch. Dec. 3, 2007).
In so ruling, the Chancellor explained:
There appears to be no dispute that, absent waiver or good cause, the attorney-client privilege
protects communications between Orrick [Special Counsel] and its client, the Special Committee.
Maxim, however, also asserts attorney-client privilege for its communications with Orrick relating to the
Special Committee’s findings, reports, presentations, and other communications, contending that,
because the Special Committee was formed at its direction in direct response to the litigation
challenging Maxim’s grants of stock options, Maxim and its Special Committee share a joint privilege.
As a result of this purported joint privilege, communications between not only the Special Committee
and Orrick, but also Maxim and Orrick would be protected. Maxim further contends that it has not
waived this privilege. Even assuming that Maxim can assert the privilege between the Special
Committee and Orrick to protect communications between Maxim and Orrick about the investigation
and report, I conclude that the privilege does not apply here because plaintiffs’ showing of good cause
vitiates it. Applying the factors set forth in Garner v. Wolfinbarger [430 F.2d 1093, 1103–04 (5th Cir.
1970), cert denied, 401 U.S. 974 (1971)], and particularly the three identified in Sealy Mattress Co. of
New Jersey, Inc. v. Sealy, Inc. [No. 8853, 1987 WL 12500, at *4 (Del. Ch. June 19, 1987)], I conclude
that no privilege has attached to the communications between Maxim and Orrick regarding the
investigation and report. Plaintiffs have demonstrated: (1) a colorable claim; (2) the unavailability of
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Chancellor ordered the defendants to include all the metadata associated with the documents
because it was needed to determine when and how the stock-option grant dates were altered and
when the Board had reviewed the metadata.
5.
In re Tyson Foods, Inc. Consolidated Shareholder Litigation.
A 1997 settlement arising out of transactions between minority shareholders of Tyson
Foods, Inc. and the family of its largest stockholder, Don Tyson, and a 2004 SEC consent order
arising out of SEC allegations that Tyson Foods’ proxy statements from 1997 to 2003 mislabeled
payments as travel and entertainment expenses underlay the plaintiffs’ fiduciary duty claims in
In re Tyson Foods, Inc. Consolidated Shareholder Litigation.232 Plaintiffs’ complaint alleged
232
information from other sources, including the lack of written final report, the inability to depose
witnesses regarding the report or investigation because of assertions of privilege, and the unavailability
of witnesses due to invocation of the Fifth Amendment privilege not to testify; and (3) the specificity
with which the information is identified. Of particular importance is the unavailability of this
information from other sources when information regarding the investigation and report of the Special
Committee is of paramount importance to the ability of plaintiffs to assess and, ultimately prove, that
certain fiduciaries of the Company breached their duties. Consequently, I conclude that no attorneyclient privilege attached to the communications between Maxim and Orrick regarding the investigation
and, therefore, these communications must be produced.
Even if, however, Maxim and its Special Committee do share a joint privilege, as to certain
communications between Orrick and the Special Committee, I conclude that plaintiffs have
demonstrated that the privilege has been waived. Plaintiffs appear to seek discovery of all
communications between Orrick and the Special Committee related to the investigation and report, in
addition to discovery of the presentation of the Special Committee’s investigation and final report to the
Special Committee and Maxim’s board of directors. Though plaintiffs have demonstrated waiver of the
privilege only as to the presentation of the report, this partial waiver operates as a complete waiver for
all communications regarding this subject matter. Therefore, I conclude that plaintiffs are entitled to all
communications between Orrick and the Special Committee related to the investigation and final report.
Communications made in the presence of third persons not for the purpose of seeking legal advice
operates as a waiver of the attorney-client privilege. On January 18 and 19, 2007, the Special Committee
presented its final oral report to Maxim’s board of directors. This report appears to be more than a mere
acknowledgement of the existence of the report and instead disclosed such details that, for example,
attendees were directed to turn in any notes taken during the presentation at the end of the meeting. In
addition to the Special Committee and Orrick, other members of the board of directors and attorneys
from Quinn Emmanuel were also in attendance. The presentation of the report constitutes a waiver of
privilege because the client, the Special Committee, disclosed its communications concerning the
investigation and final report to third parties—the individual director defendants and Quinn
Emmanuel—whose interests are not common with the client, precluding application of the common
interest exception to protect the disclosed communications. The individual defendants, though directors
on the board of Maxim, cannot be said to have interests that are so parallel and non-adverse to those of
the Special Committee that they could reasonably be characterized “joint venturers.” The Special
Committee was formed to investigate wrongdoing and in response to litigation in which certain directors
were named as individual defendants. This describes a relationship more akin to one adversarial in
nature. Though the presence of counsel that seemingly acts in a dual capacity as counsel for both Maxim
(before the SEC) and the individual defendants in this litigation may confuse the issue of whether the
director defendants attended the January meetings in a fiduciary—not individual—capacity, any
apparent confusion may now be dismissed because the individual director defendants specifically rely
on the findings of the report for exculpation as individuals defendants. Thus, there can be no doubt that
the common interest exception is inapplicable to extend the protection of the attorney-client privilege to
the communications disclosed at the January board meetings. Therefore, those communications relating
to the final report, including any materials distributed or collected at meetings between the Board
members and the Special Committee, must be produced.
See Byron F. Egan, Responsibilities of M&A Professionals After the Sarbanes-Oxley Act (Oct. 4, 2007) at A-2, A-3,
which can be found at http://www.jw.com/site/jsp/publicationinfo.jsp?id=838.
2007 WL 416132 (Del.Ch. Feb. 6, 2007).
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three particular types of Board malfeasance: (1) approval of consulting contracts that provided
lucrative and undisclosed benefits to corporate insiders; (2) grants of “spring-loaded” stock
options to insiders;233 and (3) acceptance of related-party transactions that favored insiders at the
expense of shareholders.
In a February 6, 2007 opinion denying a motion to dismiss allegations that the directors
breached their fiduciary duties in approving compensation, Chancellor Chandler wrote:
Plaintiffs’ complaint as to the approval of the compensation amounts to a claim
for excessive compensation. To maintain such a claim, plaintiffs must show
either that the board or committee that approved the compensation lacked
independence (in which case the burden shifts to the defendant director to show
that the compensation was objectively reasonable), or to plead facts sufficient to
show that the board or committee lacked good faith in making the award.
Assuming that this standard is met, plaintiffs need only allege some specific facts
suggesting unfairness in the transaction in order to shift the burden of proof to
defendants to show that the transaction was entirely fair.
***
The report of the Compensation Committee in the same proxy, however,
discusses salaries, bonuses, options and stock, but remains conspicuously silent
about other annual compensation.
It is thus reasonable to infer at this stage that the Compensation
Committee did not approve or review the other annual compensation. Plaintiffs
easily meet their further burden to allege some fact suggesting that the
transactions were unfair to shareholders: the transactions and their related lack of
disclosure undeniably exposed the company to SEC sanctions.
With respect to the option spring-loading issues, the Chancellor wrote:
Whether a board of directors may in good faith grant spring-loaded
options is a somewhat more difficult question than that posed by options
backdating, a practice that has attracted much journalistic, prosecutorial, and
judicial thinking of late. At their heart, all backdated options involve a
fundamental, incontrovertible lie: directors who approve an option dissemble as
to the date on which the grant was actually made. Allegations of spring-loading
implicate a much more subtle deception.
Granting spring-loaded options, without explicit authorization from
shareholders, clearly involves an indirect deception. A director’s duty of loyalty
includes the duty to deal fairly and honestly with the shareholders for whom he is
a fiduciary. It is inconsistent with such a duty for a board of directors to ask for
233
See Appendix B for discussions of “backdated” and “spring-loaded” stock options; see C. Stephen Bigler & Pamela H.
Sudell, Delaware Law Developments: Stock Option Backdating and Spring-Loading, 40 Rev. Sec. & Comm. Reg. 115
(May 16, 2007).
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shareholder approval of an incentive stock option plan and then later to distribute
shares to managers in such a way as to undermine the very objectives approved by
shareholders. This remains true even if the board complies with the strict letter of
a shareholder-approved plan as it relates to strike prices or issue dates.
The question before the Court is not, as plaintiffs suggest, whether springloading constitutes a form of insider trading as it would be understood under
federal securities law. The relevant issue is whether a director acts in bad faith by
authorizing options with a market-value strike price, as he is required to do by a
shareholder-approved incentive option plan, at a time when he knows those shares
are actually worth more than the exercise price. A director who intentionally uses
inside knowledge not available to shareholders in order to enrich employees while
avoiding shareholder-imposed requirements cannot, in my opinion, be said to be
acting loyally and in good faith as a fiduciary.
This conclusion, however, rests upon at least two premises, each of which
should be (and, in this case, has been) alleged by a plaintiff in order to show that a
spring-loaded option issued by a disinterested and independent board is
nevertheless beyond the bounds of business judgment. First, a plaintiff must
allege that options were issued according to a shareholder-approved employee
compensation plan. Second, a plaintiff must allege that the directors that
approved spring-loaded (or bullet-dodging) options (a) possessed material nonpublic information soon to be released that would impact the company’s share
price, and (b) issued those options with the intent to circumvent otherwise valid
shareholder-approved restrictions upon the exercise price of the options. Such
allegations would satisfy a plaintiff’s requirement to show adequately at the
pleading stage that a director acted disloyally and in bad faith and is therefore
unable to claim the protection of the business judgment rule. Of course, it is
conceivable that a director might show that shareholders have expressly
empowered the board of directors (or relevant committee) to use backdating,
spring-loading, or bullet-dodging as part of employee compensation, and that such
actions would not otherwise violate applicable law. But defendants make no such
assertion here.
Plaintiffs’ have alleged adequately that the Compensation Committee
violated a fiduciary duty by acting disloyally and in bad faith with regard to the
grant of options. I therefore deny defendants’ motion to dismiss Count III as to
the seven members of the committee who are implicated in such conduct.
With the several related party transactions, the plaintiffs did not challenge the
disinterestedness or independence of the special committee and thus the Chancellor focused on
whether the plaintiffs alleged sufficient facts to show that “the board knew that material
decisions were being made without adequate deliberation in a manner that suggests they did not
care that shareholders would suffer a loss.” Elaborating on this scienter-based test, the
Chancellor wrote:
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There is an important distinction between an allegation of non-deliberation and
one of inadequate deliberation. It is easy to conclude that a director who fails to
consider an issue at all has violated at the very least a duty of due care. In
alleging inadequate deliberation, however, a successful complaint will need to
make detailed allegations with regard to the process by which a committee
conducted its deliberations: the amount of time a committee took in considering a
specific motion, for instance, or the experts relied upon in making a decision.
In declining to dismiss disclosure violation claims based on the DGCL § 102(b)(7)
exculpatory clause in the certificate of incorporation of Tyson Foods, the Chancellor
commented:
Disclosure violations may, but do not always, involve violations of the duty of
loyalty. A decision violates only the duty of care when the misstatement or
omission was made as a result of a director’s erroneous judgment with regard to
the proper scope and content of disclosure, but was nevertheless made in good
faith. Conversely, where there is reason to believe that the board lacked good
faith in approving a disclosure, the violation implicates the duty of loyalty.
It is too early for me to conclude that the alleged failures to disclose do not
implicate the duty of loyalty.
Thereafter, the outside directors moved for a judgment on the pleadings. The Chancellor
denied this motion in an opinion dated August 15, 2007 that clarified that Tyson’s shareholderapproved stock option plan permitted the grant of both “incentive stock options,” which under
IRS rules must be granted at not less than fair market value on the date of grant, and “nonqualified stock options,” which Tyson’s Compensation Committee might make exercisable at
any price. In denying this motion to dismiss on duty of loyalty grounds, the Chancellor
explained:
Delaware law sets forth few bright-line rules guiding the relationship
between shareholders and directors. Nor does the law require corporations to
adopt complex sets of articles and bylaws that govern the method by which
corporate decisions will be made. Instead, shareholders are protected by the
assurance that directors will stand as fiduciaries, exercising business judgment in
good faith, solely for the benefit of shareholders.
Case law from the Supreme Court, as well as this Court, is replete with
language describing the nature of this relationship. The affairs of Delaware
corporations are managed by their board of directors, who owe to shareholders
duties of unremitting loyalty. This means that their actions must be taken in the
good faith belief that they are in the best interests of the corporation and its
stockholders, especially where conflicts with the individual interests of directors
are concerned. The question whether a corporation should pursue a lawsuit
against an errant director belongs to the board, and will not be taken from
disinterested directors, or those who retain their independence from those who
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might not have shareholder interests firmly at heart. When those same directors
communicate with shareholders, they also must do so with complete candor.
Loyalty. Good faith. Independence. Candor. These are words pregnant
with obligation. The Supreme Court did not adorn them with half-hearted
adjectives. Directors should not take a seat at the board table prepared to offer
only conditional loyalty, tolerable good faith, reasonable disinterest or formalistic
candor. It is against these standards, and in this spirit, that the alleged actions of
spring-loading or backdating should be judged.
***
When directors seek shareholder consent to a stock incentive plan, or any
other quasi-contractual arrangement, they do not do so in the manner of a devil in
a dime-store novel, hoping to set a trap with a particular pattern of words. Had the
2000 Tyson Stock Incentive Plan never been put to a shareholder vote, the nature
of a spring-loading scheme would constitute material information that the Tyson
board of directors was obligated to disclose to investors when they revealed the
grant. By agreeing to the Plan, shareholders did not implicitly forfeit their right to
the same degree of candor from their fiduciaries.
Defendants protest that deceptive or deficient proxy disclosures cannot
form the basis of a derivative claim challenging the grant of these options,
asserting that “Tyson’s later proxy disclosures concerning the challenged option
grants are temporally and analytically distinct from the option grants themselves.”
* * * Where a board of directors intentionally conceals the nature of its earlier
actions, it is reasonable for a court to infer that the act concealed was itself one of
disloyalty that could not have arisen from a good faith business judgment. The
gravamen of Count III lies in the charge that defendants intentionally and
deceptively channeled corporate profits to chosen executives (including members
of Don Tyson’s family). Proxy statements that display an uncanny parsimony
with the truth are not “analytically distinct” from a series of improbably fortuitous
stock option grants, but rather raise an inference that directors engaged in later
dissembling to hide earlier subterfuge. The Court may further infer that grants of
spring-loaded stock options were both inherently unfair to shareholders and that
the long-term nature of the deceit involved suggests a scheme inherently beyond
the bounds of business judgment.
In retrospect, the test applied in the February 6, 2007 Opinion was,
although appropriate to the allegations before the Court at the time, couched in
too limited a manner. Certainly the elements listed describe a claim sufficient to
show that spring-loading would be beyond the bounds of business judgment.
Given the additional information now presented by the parties, however, I am not
convinced that allegations of an implicit violation of a shareholder-approved stock
incentive plan are absolutely necessary for the Court to infer that the decision to
spring-load options lies beyond the bounds of business judgment. Instead, I find
that where I may reasonably infer that a board of directors later concealed the true
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nature of a grant of stock options, I may further conclude that those options were
not granted consistent with a fiduciary’s duty of utmost loyalty.234
6.
Desimone v. Barrows
Following the Delaware Chancery Court decisions in Ryan v. Gifford235 and In re Tyson
Foods, Inc. Consolidated Shareholder Litigation236 in which derivative claims involving
backdated and spring-loaded options survived motions to dismiss, the Delaware Chancery court
decision in Desimone v. Barrows237 demonstrates that cases involving such options issues can be
very fact specific and may not result in director liability, even where there have been internal,
SEC and Department of Justice investigations finding option granting irregularities. In
Desimone v. Barrows, the issuer (Sycamore Networks, Inc.) essentially admitted in its SEC
filings that many of its option grants were backdated and this truth was not disclosed until after
an internal investigation. Based on allegations in an internal memorandum that options granted
to six rank and file employees were backdated and the issuer’s restatement of earnings after an
internal investigation following that memorandum was revealed to the Board, plaintiff brought a
derivative action against recipients of allegedly improper grants. The action involved a plan that
permitted grants of options below market, which distinguished it from the plan in Ryan v. Gifford
that required that options be granted at fair market value. Plaintiff endeavored to stigmatize three
distinct classes of grants: (1) grants to rank and file employees that may have been effected by
officers without Board or Compensation Committee approval, (2) grants to officers which
involved Compensation Committee approval, although no particular facts were alleged that the
Compensation Committee knew of the backdating, and (3) grants to outside directors that were
awarded annually after the annual meeting of stockholders pursuant to specific stockholder
approval of both the amount and the timing of the grants but that allegedly had fortuitous timing..
The Court dismissed plaintiff’s complaint on the basis that the complaint did not plead
particularized facts establishing demand excusals as to the grants to rank and file employees and
to officers because there were no specific facts plead that a majority of the Board was unable to
independently decide whether to pursue the claims.238 Because a majority of the directors
received the director options and, thus, likely would be unable to act independently of their
interest therein, demand was excused with respect to the director option claims, but the
complaint did not survive the motion to dismiss because there were no particular allegations that
the regular director option grants did not conform to non-discriminatory arrangement approved
by the stockholders. In explaining, in a section captioned “Proceed With Care: The Legal
Complexities Raised By Various Options Practices,” how the allegations in the Desimone v.
Barrows complaint differed from those in Ryan and Tyson, Vice Chancellor Strine wrote:
234
235
236
237
238
In re Tyson Foods, Inc. Consolidated Shareholder Litigation, C.A. No. 1106-CC (Del. Ch. August 15, 2007); see
Elloway v. Pate, 238 S.W.3d 882 (Tex.App.—Houston [14th Dist.] 2007) (a Texas court applying Delaware law
affirmed jury verdicts in favor of the defendant directors, holding that the directors did not breach their fiduciary duties
in approving broad based option grants during confidential merger negotiations at exercise prices below the merger
price).
See notes 224-231 and related text, supra.
See notes 232-234 and related text, supra.
Del. Ch. CA No. 2210-VCS June 7, 2007.
See notes 99 and 100, supra, regarding demand excusal standard under Delaware Chancery Court Rule 23.1.
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As in Ryan and Tyson, issues of backdating and spring loading are
presented here. But there are some very important differences between the
allegations made here about the Employee, Officer, and Outside Director Grants,
and those that were made in Ryan and Tyson. The first is that the Incentive Plan,
the stockholder-approved option plan under which all of the Employee and
Officer Grants were made, did not by its terms require that all options be priced at
fair market value on the date of the grant. Rather, the Incentive Plan gave
Sycamore’s directors discretion to set the exercise price of the options and
expressly permitted below-market-value options to be granted. This case thus
presents a different question than those involved in Ryan and Tyson, which is
whether corporate officials breach their fiduciary duties when they, despite having
express permission under a stockholder-approved option plan to grant belowmarket options, represent to shareholders, markets, and regulatory authorities that
they are granting fair-market-value options when in fact they are secretly
manipulating the exercise price of the option.
As to that question, there is also the subsidiary question of whether the
means matters. For example, do backdating and spring loading always have the
same implications? In this respect, the contraventions of stockholder-approved
option plans that allegedly occurred in Ryan and Tyson are not the only cause for
concern. The tax and accounting fraud that flows from acts of concealed options
backdating involve clear violations of positive law. But even in such cases, there
are important nuances about who bears responsibility when the corporation
violates the law, nuances that turn importantly on the state of mind of those
accused of involvement.
That point highlights the second important difference between this case
and Ryan and Tyson. In contrast to the plaintiff in Ryan, plaintiff Desimone has
pled no facts to suggest even the hint of a culpable state of mind on the part of any
director. Likewise, Desimone has not, as was done in Tyson, pled any facts to
suggest that any director was incapable of acting independently of the recipients
of any of the Employee or Officer Grants. The absence of pled facts of these kinds
underscores the utility of a cautious, non-generic approach to addressing the
various options practices now under challenge in many lawsuits. The various
practices have jurisprudential implications that are also diverse, not identical, and
the policy purposes of different bodies of related law (corporate, securities, and
tax) could be lost if courts do not proceed with prudence. Indeed, within the
corporate law alone, there are subtle issues raised by options practices.239
239
Slip Opinion pp. 34-36; see In Re: F5 Networks Derivative Litigation, 2007 U.S.Dist. LEXIS 56390 (W.D. Wash.,
Aug. 1, 2007), In re CNET Networks Inc. Derivative Litigation, No. C-06-3817 WHA, 2007 WL 1089690 (N.D. Cal.
Apr. 11, 2007), In re Linear Technology Corp. Derivative Litigation, 2006 WL 3533024 (N.D.Cal. Dec. 7, 2006), and
each of which was an options-backdating derivative action in which the plaintiff’s complaint was dismissed for failure
to plead with particularity that demand on the board was excused as futile under FRCP 23.1 and which also recognized
that, even in the options-backdating context, in order to allege breach of fiduciary duty with the necessary particularity,
derivative plaintiffs must allege more than that improper backdating occurred and that the defendant directors had such
involvement that they breached their fiduciary duties; but see In re Zoran Corporation Derivative Litigation, 2007 WL
1650948 (N.D. Cal. June 5, 2007), in which the same district court as in the CNET case found that facts alleging
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7.
Teachers’ Retirement System of Louisiana v. Aidinoff
In Teachers’ Retirement System of Louisiana v. Aidinoff,240 the plaintiff brought suit on
behalf of American International Group (“AIG”) against Maurice R. Greenberg (AIG’s former
CEO) and others, relating to an alleged compensation scheme, pursuant to which senior AIG
executives became stockholders of a separate company which collected substantial commissions
and other payments from AIG, effectively for no separate services rendered. In upholding the
complaint as against defendants’ motions to dismiss, the Delaware Court of Chancery rejected as
determinative the defense that the relevant arrangements were approved annually by the Board
and focused upon the complaint’s allegations that the Board relied “blindly” on Greenberg, an
interested defendant, to approve the relationship “after hearing a short song-and-dance from him
annually.” The Court also noted that the outside directors “did not employ any integrityenhancing device, such as a special committee, to review the…relationship and to ensure that the
relationship was not tainted by the self-interest of AIG executives who owned large stakes” in
the second company. While stressing that the “informed approval of a conflict transaction by an
independent Board majority remains an important cleansing device under our law and can
insulate the resulting decision from fairness review under the appropriate circumstances,” the
Court also made clear that to avail itself of that cleansing device, “the conflicted insider gets no
credit for bending a curve ball past a group of uncurious Georges who fail to take the time to
understand the nature” of the transactions at issue.
8.
Valeant Pharmaceuticals v. Jerney
In Valeant Pharmaceuticals International v. Jerney,241 the Delaware Court of Chancery
in a post-trial opinion found that compensation received by a former director and president of
ICN Pharmaceuticals, Inc. (now known as Valeant Pharmaceuticals International), Adam Jerney,
was not entirely fair, held him liable to disgorge a $3 million transaction bonus paid to him, and
also held Jerney liable for (i) his 1/12 share (as one of 12 directors) of the costs of the special
litigation committee investigation that led to the litigation and (ii) his 1/12 share of the bonuses
paid by the Board to non-director employees. The Court further ordered him to repay half of the
$3.75 million in defense costs that ICN paid to Jerney and the primary defendant, ICN Chairman
and CEO Milan Panic. Pre-judgment interest at the legal rate, compounded monthly, was
granted on all amounts.
240
241
backdating were sufficiently pled, and that demand was, therefore, excused; in Zoran, the plaintiffs based their strategy
on the CNET opinion, providing exactly the sort of method and pedigree information for the backdating claims whose
absence the CNET court used as a basis for rejecting the CNET plaintiffs. Cf. Indiana Electrical Workers Pension
Fund v. Millard, S.D.N.Y., No. 07 Civ. 172 (JGK), 7/24/07) (breach of fiduciary duty class action originally brought by
a pension fund against officers and directors of a company in which the fund invested held not preempted by the 1998
Securities Litigation Uniform Standards Act (“SLUSA”) due to the “Delaware carve-out,” which exempts specified
class actions based on the statutory or common law of the issuer’s state of incorporation; the fund contended in the
class action it brought in a New York state court that the defendant officers and directors breached their fiduciary duty
of disclosure under Delaware law by making misrepresentations and failing to disclose material facts about an improper
stock option backdating scheme, thereby persuading shareholders to authorize an increase in the number of shares
available in the company’s stock option plan; Lee G. Dunst, Private Civil Litigation: The Other Side of Stock Option
Backdating, 39 Sec. Reg. & L. Rep. (BNA) 1344 (Sept. 3, 2007).
900 A.2d 654 (Del. Ch. 2006).
2007 WL 704935 (Del. Ch. March 1, 2007).
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The Valeant case illustrates how compensation decisions by a Board can be challenged
after a change in control by a subsequent Board. The litigation was initiated by dissident
stockholders as a stockholder derivative action but, following a change in control of the Board, a
special litigation committee of the Board chose to realign the corporation as a plaintiff. As a
result, with the approval of the Court, ICN took over control of the litigation. During the course
of discovery, ICN reached settlement agreements with all of the non-management directors,
leaving Panic and Jerney as the only remaining defendants at the trial. After trial, ICN reached a
settlement agreement with Panic, leaving only Jerney.
The transaction on which the bonus was paid was a reorganization of ICN into three
companies; a U.S. unit, an international unit and a unit holding the rights to its antiviral
medication, shares of which would be sold to the public in a registered public offering (“IPO”).
After the IPO but before the reorganization was completed, control of the Board changed as a
result of the election of additional dissident directors.
The ensuing litigation illustrates the risks to all involved when the compensation
committee is not independent and disinterested. Executive compensation is like any other
transaction between a corporation and its management – it is voidable unless the statutory
requirements for validation of interested director transactions are satisfied.242 In Delaware a
contract between a director and the director’s corporation is voidable due to the director’s
interest unless (i) the transaction or contract is approved in good faith by a majority of the
disinterested directors after the material facts as to the relationship or interest and as to the
transaction or contract are disclosed or known to the directors, (ii) the transaction or contract is
approved in good faith by shareholders after the material facts as to the relationship or interest
and as to the transaction or contract is disclosed or known to the shareholders, or (iii) the
transaction or contract is fair to the corporation as of the time it is authorized, approved or
ratified by the directors or shareholders of the corporation.243 Neither the ICN compensation
committee nor the ICN Board was disinterested because all of the directors were receiving some
of the questioned bonuses.244 Since the compensation had not been approved by the
stockholders, the court applied the “entire fairness” standard in reviewing the compensation
arrangements, which placed the burden on the defendant director and officer of establishing both
components of entire fairness: fair dealing and fair price. “Fair dealing” addresses the
“questions of when the transaction was timed, how it was initiated, structured, negotiated,
disclosed to the directors, and how the approvals of the directors and the stockholders were
obtained.”245 “Fair price” requires that the transaction be substantively fair by examining “the
economic and financial considerations.”246
242
243
244
245
246
See notes 156-163 and related text, supra.
Id.
The Court noted that each of the three directors on the compensation committee received a $330,500 cash bonus and
“were clearly and substantially interested in the transaction they were asked to consider.” Further, the Court
commented “that at least two of the committee members were acting in circumstances which raise questions as to their
independence from Panic. Tomich and Moses had been close personal friends with Panic for decades. Both were in
the process of negotiating with Panic about lucrative consulting deals to follow the completion of their board service.
Additionally, Moses, who played a key role in the committee assignment to consider the grant of 5 million options to
Panic, had on many separate occasions directly requested stock options for himself from Panic.”
Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983).
Id.
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The fair dealing prong of the entire fairness led the Court to scrutinize processes of the
compensation committee. The compensation committee had obtained a report supporting the
bonuses from Towers Perrin, a well-regarded compensation consultant, and claimed that it was
protected in relying on the report of this expert. However, the compensation consultant who
prepared the compensation report on which the compensation committee was relying was
initially selected by management, was hired to justify a plan developed by management, had
initially criticized the amounts of the bonuses and then only supported them after further
meetings with management, and opined in favor of the plan despite being unable to find any
comparable transactions. As a result, the Court held that reliance on the compensation report did
not provide Jerney with a defense under DGCL § 141(e), which provides that a director will be
“fully protected” in relying on experts chosen with reasonable care.247 The Court explained: “To
hold otherwise would replace this court’s role in determining entire fairness under 8 Del. C. sec.
144 with that of various experts hired to give advice....” The Court also separately examined the
consultant’s work and concluded that it did not meet the standard for DGCL § 141(e) reliance.
The Court rejected an argument that the Company’s senior officers merited bonuses
comparable to those paid by outside restructuring experts: “Overseeing the IPO and spin-off
were clearly part of the job of the executives at the company. This is in clear contrast to an
outside restructuring expert...”
The Court held that doctrines of common law and statutory contribution would not apply
to a disgorgement remedy for a transaction that was voidable under DGCL § 144. Hence Jerney
was required to disgorge the entirety of his bonus without any ability to seek contribution from
other defendants or a reduction in the amount of the remedy because of the settlements executed
by the other defendants.
The ICN opinion shows the significant risks that directors face when entire fairness is the
standard of review. The opinion also shows the dangers of transactions that confer material
benefits on outside directors, thereby resulting in the loss of business judgment rule protection.
Although compensation decisions made by independent boards are subject to great deference,
that deference disappears when there is not an independent board and entire fairness is the
standard. The Court in Valeant explained: “Where the self-compensation involves directors or
officers paying themselves bonuses, the court is particularly cognizant to the need for careful
scrutiny.”
C.
Non-Profit Corporations.
The compensation of directors and officers of non-profit corporations can raise conflict of
interest issues248 comparable to those discussed above in respect of the compensation of directors
247
248
See notes 622-624 and related text, infra.
TBOC § 22.230 parallels Article 2.30 of the Texas Non-Profit Corporation Act and provides as follows:
Sec. 22.230. CONTRACTS OR TRANSACTIONS INVOLVING INTERESTED DIRECTORS,
OFFICERS, AND MEMBERS. (a) This section applies only to a contract or transaction between a
corporation and:
(1) one or more of the corporation's directors, officers, or members; or
(2) an entity or other organization in which one or more of the corporation's directors, officers, or
members:
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and officers of for-profit corporations.249 Further, since non-profit corporations often seek to
qualify for exemption from federal income taxation under § 501(c)(3) of the Internal Revenue
Code of 1986, as amended (the “IRC”), as organizations organized and operated exclusively for
charitable, religious, literary or scientific purposes and whose earnings do not inure to the benefit
of any private shareholders or individuals, the compensation of directors and officers of nonprofit corporations can be subject to scrutiny by the Internal Revenue Service (“IRS”).250
Excessive compensation can be deemed the sort of private inurement that could cause the
organization to lose its status as an exempt organization under the IRC and subject the recipient
to penalties and other sanctions under the IRC.251
249
250
251
(A) is a managerial official or a member; or
(B) has a financial interest.
(b) An otherwise valid contract or transaction is valid notwithstanding that a director, officer, or member of
the corporation is present at or participates in the meeting of the board of directors, of a committee of the
board, or of the members that authorizes the contract or transaction, or votes to authorize the contract or
transaction, if:
(1) the material facts as to the relationship or interest and as to the contract or transaction are
disclosed to or known by:
(A) the corporation's board of directors, a committee of the board of directors, or the
members, and the board, the committee, or the members in good faith and with ordinary
care authorize the contract or transaction by the affirmative vote of the majority of the
disinterested directors, committee members or members, regardless of whether the
disinterested directors, committee members or members constitute a quorum; or
(B) the members entitled to vote on the authorization of the contract or transaction, and
the contract or transaction is specifically approved in good faith and with ordinary care
by a vote of the members; or
(2) the contract or transaction is fair to the corporation when the contract or transaction is
authorized, approved, or ratified by the board of directors, a committee of the board of directors, or
the members.
(c) Common or interested directors or members of a corporation may be included in determining the
presence of a quorum at a meeting of the board, a committee of the board, or members that authorizes the
contract or transaction.
See American Law Institute, Principals of the Law of Nonprofit Organizations § 330 (Tentative Draft No. 1 March 19,
2007); ABA Guidebook for Directors of Nonprofit Corporations (1933).
See IRS Report on Exempt Organizations Executive Compensation Compliance Project--Parts I and II (March 2007),
which can be found at http://www.irs.gov/pub/irs-tege/exec._comp._final.pdf.
Id. On February 2, 2007, the IRS issued voluntary guidelines for exempt corporations entitled Good Governance
Practices
for
501(c)(3)
Organizations,
which
can
be
found
at
http://www.irs.gov/charities/charitable/article/0,,id=167626,00.html and which are intended to help organizations
comply with the requirements for maintaining their tax exempt status under the IRC. In addition to having a Board
composed of informed individuals who are active in the oversight of the organization’s operations and finances, the
guidelines suggest the following nine specific practices that, taken together, the IRS believes every exempt
organization should adopt in order to avoid potential compliance problems:
Adopt a clearly articulated mission statement that makes manifest its goals and activities.
Adopt a code of ethics setting ethical standards for legal compliance and integrity.
The directors exercise that degree of due diligence that allows them to ensure that each such
organization’s charitable purpose is being realized in the most efficient manner possible.
Adopt a conflicts of interest policy and require the filing of a conflicts of interest disclosure form annually
by all of its directors.
Post on its website or otherwise make available to the public all of its tax forms and financial statements.
Ensure that its fund-raising activities comply fully with all federal and state laws and that the costs of such
fund-raising are reasonable.
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The fiduciary duties of directors applicable to compensation process are comparable to
those of a for-profit corporation discussed elsewhere herein.252 Like directors of for-profit
corporations, directors of non-profit corporations are increasingly subject to scrutiny under
fiduciary duty principles with respect to how they handle the compensation of management.
In People ex rel Spitzer v. Grasso,253 the New York Attorney General challenged the
compensation paid or payable to Richard Grasso, the former CEO of the New York Stock
Exchange (which at the relevant times was organized under the New York Not-for-Profit Law)
as unreasonable, unlawful and ultra vires.254 The litigation ensued after disclosures by the NYSE
of a new employment contract with Grasso providing for an immediate lump sum payment of
$139.5 million, which led to the Chairman of the SEC writing to the NYSE that Grasso’s pay
package “raises serious questions regarding the effectiveness of the NYSE’s current governance
structure.” The resulting furor led the NYSE’s Board to request Grasso’s resignation, which he
tendered.255 An internal investigation led by special independent counsel was highly critical of
Grasso’s level of compensation and suggested he had played an improper role in setting his own
compensation by selecting the Board members who set his compensation. The Court denied
cross motions for summary judgment as to the reasonableness of Grasso’s compensation
generally, but found that the acceleration of certain deferred compensation arrangements was not
in strict conformity with the plans256 and, thus, resulted in illegal loans which Grasso was
252
253
254
255
256
Operate in accordance with an annual budget, and, if the organization has substantial assets or revenues,
an annual audit should be conducted. Further, the Board should establish an independent audit committee to
work with and oversee any outside auditor hired by the organization.
Pay no more than reasonable compensation for services rendered and generally either not compensate
persons for serving on the board of directors or do so only when an appropriate committee composed of
persons not compensated by the organization determines to do so.
Adopt a policy establishing standards for document integrity, retention, and destruction, including
guidelines for handling electronic files.
TBOC § 22.221 parallels Article 2.26 of the Texas Non-Profit Corporation Act and provides as follows with respect to
the duties of directors of a non-profit corporation organized under the TBOC:
Sec. 22.221. GENERAL STANDARDS FOR DIRECTORS.
(a) A director shall discharge the director's duties, including duties as a committee member, in good faith,
with ordinary care, and in a manner the director reasonably believes to be in the best interest of the
corporation.
(b) A director is not liable to the corporation, a member, or another person for an action taken or not taken as
a director if the director acted in compliance with this section. A person seeking to establish liability of a
director must prove that the director did not act:
(1) in good faith;
(2) with ordinary care; and
(3) in a manner the director reasonably believed to be in the best interest of the corporation.
13 Misc. 3rd 1227A, 2006 WL 3016952 (N.Y. Sup. Oct. 18, 2006).
The Texas Attorney General has also been active in respect of compensation paid to officers and directors of Texas
non-profit corporations. See John W. Vinson, The Charity Oversight Authority of the Texas Attorney General, 35 St.
Mary’s L.J. 243 (2004).
Grasso tendered his resignation without giving the written notice required under his employment agreement for a
termination by the NYSE without cause or by Grasso for good reason, which would have entitled him to additional
severance payments. The Court held that Grasso’s failure to give this written notice was fatal to his claim for these
additional severance payments under both his contract and New York law.
The plans could have been amended by the Board directly, but the parties had attempted to effect the changes by
separate agreements with Grasso, which the Court found not to be in conformity with the plans. The Court’s holding
seems harsh and teaches that formalities can be important when dealing with compensation issues.
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obligated to repay. The Court found that Grasso had breached his fiduciary duties of care and
loyalty in failing to fully inform the Board as to the amount of his accumulated benefits as it was
considering granting him additional benefits.
On appeal, the New York Appellate Division,257 in a 4-to-1 decision, held the New York
Attorney General did not have authority to assert four of the six causes of action in which the
trial court had allowed recovery from Grasso on a showing that compensation was excessive.
The other two causes of action, which were not subject to the appeal, required a showing of fault:
(1) the payments were unlawful (i.e. not reasonable) and Grasso knew of their unlawfulness; and
(2) violation of fiduciary duty by influencing and accepting excessive compensation.
V.
Standards of Review in M&A Transactions.
A.
Texas Standard of Review.
Possibly because the Texas business judgment rule, as articulated in Gearhart, protects so
much director action, the parties and the courts in the two leading cases in the takeover context
have concentrated on the duty of loyalty in analyzing the propriety of the director conduct. This
focus should be contrasted with the approach of the Delaware courts which often concentrates on
the duty of care.
To prove a breach of the duty of loyalty, it must be shown that the director was
“interested” in a particular transaction.258 In Copeland, the court interpreted Gearhart as
indicating that “[a]nother means of showing interest, when a threat of takeover is pending, is to
demonstrate that actions were taken with the goal of director entrenchment.”259
Both the Gearhart and Copeland courts assumed that the defendant directors were
interested, thus shifting the burden to the directors to prove the fairness of their actions to the
corporation.260 Once it is shown that a transaction involves an interested director, the transaction
is “subject to strict judicial scrutiny but [is] not voidable unless [it is] shown to be unfair to the
corporation.”261 “[T]he burden of proof is on the interested director to show that the action under
fire is fair to the corporation.”262
In analyzing the fairness of the transaction at issue, the Fifth Circuit in Gearhart relied on
the following criteria set forth by Justice Douglas in Pepper v. Litton, 308 U.S. 295, 306-07
(1939):
A director is a fiduciary. So is a dominant or controlling stockholder or group of
stockholders. Their powers are powers in trust. Their dealings with the
corporation are subjected to rigorous scrutiny and where any of their contracts or
engagements with the corporation is challenged the burden is on the director or
257
258
259
260
261
262
People ex rel Spitzer v. Grasso, 2007 NY Slip Op 03990 (Supreme Court, Appellate Division, May 8, 2007).
Gearhart, 741 F.2d. at 719; Copeland, 706 F. Supp. at 1290.
Copeland, 706 F. Supp. at 1290-91.
Gearhart, 741 F.2d at 722; Copeland, 706 F. Supp. at 1291-92.
Gearhart, 741 F.2d at 720; see also Copeland, 706 F. Supp. at 1291.
Gearhart, 741 F.2d at 720; see also Copeland, 706 F. Supp. at 1291.
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stockholder not only to prove the good faith of the transaction but also to show its
inherent fairness from the viewpoint of the corporation and those interested
therein. The essence of the test is whether or not under all the circumstances the
transaction carries the earmarks of an arm’s length bargain. If it does not, equity
will set it aside.263
In Gearhart, the court also stated that a “challenged transaction found to be unfair to the
corporate enterprise may nonetheless be upheld if ratified by a majority of disinterested directors
or the majority of stockholders.”264
In setting forth the test for fairness, the Copeland court also referred to the criteria
discussed in Pepper v. Litton and cited Gearhart as controlling precedent.265 In analyzing the
shareholder rights plan (also known as a “poison pill”) at issue, however, the court specifically
cited Delaware cases in its after-the-fact analysis of the fairness of the directors’ action.266
Whether a Texas court following Gearhart would follow Delaware case law in its fairness
analysis remains to be seen, especially in light of the Fifth Circuit’s complaint in Gearhart that
the lawyers focused on Delaware cases and failed to deal with Texas law:
We are both surprised and inconvenienced by the circumstance that, despite their
multitudinous and voluminous briefs and exhibits, neither plaintiffs nor
defendants seriously attempt to analyze officers’ and directors’ fiduciary duties or
the business judgment rule under Texas law. This is particularly so in view of the
authorities cited in their discussions of the business judgment rule: Smith and
Gearhart argue back and forth over the applicability of the plethora of out-of-state
cases they cite, yet they ignore the fact that we are obligated to decide these
aspects of this case under Texas law. We note that two cases cited to us as
purported Texas authority were both decided under Delaware law. . . .267
Given the extent of Delaware case law dealing with director fiduciary duties, it is certain,
however, that Delaware cases will be cited and argued by corporate lawyers negotiating
transactions and handling any subsequent litigation. The following analysis, therefore, focuses
on the pertinent Delaware cases.
B.
Delaware Standard of Review.
An examination only of the actual substantive fiduciary duties of corporate directors
provides somewhat of an incomplete picture. Compliance with those duties in any particular
circumstance will be informed by the standard of review that a court would apply when
evaluating a board decision that has been challenged.
Under Delaware law, there are generally three standards against which the courts will
measure director conduct. As articulated by the Delaware courts, these standards provide
263
264
265
266
267
Gearhart, 741 F.2d at 723 (citations omitted).
Id. at 720 (citation omitted).
Copeland, 706 F. Supp. at 1290-91.
Id. at 1291-93.
Gearhart, 741 F.2d. at 719 n.4.
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important guidelines for directors and their counsel as to the process to be followed for director
action to be sustained. In the context of considering a business combination transaction, these
standards are:
(i)
business judgment rule -- for a decision to remain independent or to approve a
transaction not involving a sale of control;
(ii)
enhanced scrutiny -- for a decision to adopt or employ defensive measures268 or to
approve a transaction involving a sale of control; and
(iii)
entire fairness -- for a decision to approve a transaction involving management or
a principal shareholder or for any transaction in which a plaintiff successfully
rebuts the presumptions of the business judgment rule.
1.
Business Judgment Rule.
The Delaware business judgment rule “is a presumption that in making a business
decision the directors of a corporation acted on an informed basis, in good faith and in the honest
belief that the action taken was in the best interests of the company.”269 “A hallmark of the
business judgment rule is that a court will not substitute its judgment for that of the board if the
latter’s decision can be ‘attributed to any rational business purpose’.”270
The availability of the business judgment rule does not mean, however, that directors can
act on an uninformed basis. Directors must satisfy their duty of care even when they act in the
good faith belief that they are acting only in the interests of the corporation and its stockholders.
Their decision must be an informed one. “The determination of whether a business judgment is
an informed one turns on whether the directors have informed themselves ‘prior to making a
business decision, of all material information reasonably available to them.’”271 In Van Gorkom,
notwithstanding a transaction price substantially above the current market, directors were held to
have been grossly negligent in, among other things, acting in haste without adequately informing
themselves as to the value of the corporation.272
268
269
270
271
272
In Williams v. Geier, 671 A.2d 1368 (Del. 1996), the Delaware Supreme Court held that an antitakeover defensive
measure will not be reviewed under the enhanced scrutiny standard when the defensive measure is approved by
stockholders. The court stated that this standard “should be used only when a board unilaterally (i.e. without
stockholder approval) adopts defensive measures in reaction to a perceived threat.” Id. at 1377.
Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984) (citation omitted); see also Brazen v. Bell Atl. Corp., 695 A.2d 43, 49
(Del. 1997); cf. David Rosenberg, Galactic Stupidity and the Business Judgment Rule, 32 J. of Corp. Law 301 (Winter
2007).
Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954 (quoting Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720
(Del. 1971)); see Stephen M. Bainbridge, Unocal at 20: Director Primacy in Corporate Takeovers, 31 DEL. J. CORP. L.
769 (2006); Andrew G.T. Moore II, The Birth of Unocal—A Brief History, 31 DEL. J. CORP. L. 865 (2006); A. Gilchrist
Sparks III, A Comment upon “Unocal at 20”, 31 DEL. J. CORP. L. 887 (2006).
Smith v. Van Gorkom, 488 A.2d 858, 872 (Del. 1985); see Bernard S. Sharfman, Being Informed Does Matter: Fine
Tuning Gross Negligence Twenty Plus Years after Van Gorkom, 62 Bus. Law. 135 (Nov. 2006).
Id. at 874.
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2.
Enhanced Scrutiny.
When applicable, enhanced scrutiny places on the directors the burden of proving that
they have acted reasonably. The key features of enhanced scrutiny are:
(1)
a judicial determination regarding the adequacy of the decision-making process
employed by the directors, including the information on which the directors based
their decision; and
(2)
a judicial examination of the reasonableness of the directors’ action in light of the
circumstances then existing.
The directors have the burden of proving that they were adequately informed and acted
reasonably.273
The reasonableness required under enhanced scrutiny falls within a range of acceptable
alternatives, which echoes the deference found under the business judgment rule.
[A] court applying enhanced judicial scrutiny should be deciding whether the
directors made a reasonable decision, not a perfect decision. If a board selected
one of several reasonable alternatives, a court should not second-guess that choice
even though it might have decided otherwise or subsequent events may have cast
doubt on the board’s determination. Thus, courts will not substitute their business
judgment for that of the directors, but will determine if the directors’ decision
was, on balance, within a range of reasonableness.274
a.
Defensive Measures.
In Unocal Corp. v. Mesa Petroleum Co.,275 the Delaware Supreme Court held that when
directors authorize takeover defensive measures, there arises “the omnipresent specter that a
board may be acting primarily in its own interests, rather than those of the corporation and its
shareholders.”276 The court reviewed such actions with enhanced scrutiny even though a
traditional conflict of interest was absent. In refusing to enjoin a selective exchange offer
adopted by the board to respond to a hostile takeover attempt, the Unocal court held that the
directors must prove that (i) they had reasonable grounds for believing there was a danger to
corporate policy and effectiveness (satisfied by showing good faith and reasonable
investigation)277 and (ii) the responsive action taken was reasonable in relation to the threat
posed (established by showing that the response to the threat was not “coercive” or “preclusive”
273
274
275
276
277
Paramount Communications Inc. v. QVC Network Inc., 637 A.2d 34, 45 (Del. 1994); see also Quickturn Design Sys.,
Inc. v. Shapiro, 721 A.2d 1281, 1290 (Del. 1998).
QVC, 637 A.2d at 45.
493 A.2d 946 (Del. 1985).
Unocal, 493 A.2d at 954.
Id. at 954-55.
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and then by demonstrating that the response was within a “range of reasonable responses” to the
threat perceived).278
b.
Sale of Control.
In Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.,279 the Delaware Supreme Court
imposed an affirmative duty on the Board to seek the highest value reasonably obtainable to the
stockholders when a sale of the company becomes inevitable.280 Then in Paramount
Communications Inc. v. QVC Network Inc.,281 when the issues were whether a poison pill could
be used selectively to favor one of two competing bidders (effectively precluding shareholders
from accepting a tender offer) and whether provisions of the merger agreement (a “no-shop”
clause, a “lock-up” stock option, and a break-up fee) were appropriate measures in the face of
278
279
280
281
Unitrin, Inc. v. Am. Gen. Corp., 651 A.2d 1361, 1387-88 (Del. 1995).
506 A.2d 173 (Del. 1985).
While Revlon placed paramount importance on directors’ duty to seek the highest sale price once their corporation is on
the block, simply pointing to a reduced purchase price because of contingent liabilities is not enough to trigger
heightened scrutiny of the directors' actions during the sale process. In Globis Partners, L.P. v. Plumtree Software, Inc.,
1577-VCP (Del. Ch. Nov. 30, 2007), the Court of Chancery dismissed at the pleading stage claims that directors failed
to fulfill their duties under Revlon because the purchase price negotiations were complicated when the Plumtree board
learned that target was in breach of a contract with the U.S. General Services Administration (the “GSA contract”), and
that a significant liability would likely result from the breach. Accordingly, target lowered its selling price in order to
induce buyer to proceed with the purchase.
After the merger was announced, plaintiff sued target and its directors derivatively, claiming that the directors breached
their fiduciary duties in agreeing to the lower sales price in order to avoid personal liability in connection with the
breached GSA contract and additional personal benefits from the merger. In dismissing the complaint, the Court first
summarized the bedrock principles of Delaware corporate law relating to directors’ fiduciary duties:
•
Directors owe a duty of “unremitting loyalty” to shareholders, and in particular, when the board has
determined to sell the company for cash or engage in a change of control transaction, it must, under Revlon,
act reasonably in order to secure the highest price reasonably available;
•
In making their decisions, however, directors enjoy the protection of the “business judgment rule” - the
“presumption that in making a business decision the directors of a corporation acted on an informed basis, in
good faith and in the honest belief that the action taken was in the best interest of the company”; and
•
If a “proper” decision-making process is followed by the directors, a court will not review the wisdom of the
decision itself; the plaintiff must plead facts challenging the directors’ decision making in order to rebut the
business judgment rule’s presumption.
As to the allegations that directors approved the merger at a sub-optimal price to avoid derivative liability, the Court
held that the plaintiff must plead facts showing: (i) that the directors faced substantial liability; (ii) that the directors
were motivated by such liability; and (iii) that the merger was pretextual. The Court chided plaintiff for failing to even
identify which fiduciary duty the directors might have breached in connection with the GSA contract, and for failing to
plead any facts at all suggesting that any board member took (or failed to take) any direct action with respect to the
GSA contract. As to whether the directors faced substantial liability due to the problems with the GSA contract, the
Court analyzed it as a Caremark “duty of oversight” claim which failed because the plaintiff did not allege “either that
[target] had no system of controls that would have prevented the GSA overcharges or that there was sustained or
systemic failure of the board to exercise oversight.” See supra Notes 58-75 and accompanying text. Turning to the last
two prongs of the analysis, the Court concluded that because the merger negotiations were well underway before the
Board became aware of the GSA contract breach, it was unlikely that the merger was motivated by this liability, or was
a pretext without a valid business purpose.
As to the second possibility, while the Court acknowledged that there was no “bright-line rule” for determining when
merger-related benefits compromise a director’s loyalty, it found list of supposed benefits to the directors and
determined that they were either immaterial (in the case of the directors’ indemnification rights and the CEO director’s
severance), untainted by conflicts of interest (acceleration of options, the value of which would increase as the purchase
price rose) or shared by all shareholders (option cash-outs).
637 A.2d 34 (Del. 1994).
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competing bids for the corporation, the Delaware Supreme Court sweepingly explained the
possible extent of enhanced scrutiny:
The consequences of a sale of control impose special obligations on the directors
of a corporation. In particular, they have the obligation of acting reasonably to
seek the transaction offering the best value reasonably available to the
stockholders. The courts will apply enhanced scrutiny to ensure that the directors
have acted reasonably.282
The rule announced in QVC places a burden on the directors to obtain the best value
reasonably available once the board determines to sell the corporation in a change of control
transaction. This burden entails more than obtaining a fair price for the shareholders, one within
the range of fairness that is commonly opined upon by investment banking firms. In Cede & Co.
v. Technicolor, Inc.,283 the Delaware Supreme Court found a breach of duty even though the
transaction price exceeded the value of the corporation determined under the Delaware appraisal
statute: “[I]n the review of a transaction involving a sale of a company, the directors have the
burden of establishing that the price offered was the highest value reasonably available under the
circumstances.”284
Although QVC mandates enhanced scrutiny of board action involving a sale of control,
certain stock transactions are considered not to involve a change in control for such purpose. In
Arnold v. Soc’y for Sav. Bancorp, the Delaware Supreme Court considered a merger between
Bancorp and Bank of Boston in which Bancorp stock was exchanged for Bank of Boston
stock.285 The shareholder plaintiff argued, among other things, that the board’s actions should be
reviewed with enhanced scrutiny because (i) Bancorp was seeking to sell itself and (ii) the
merger constituted a change in control because the Bancorp shareholders were converted to
minority status in Bank of Boston, losing the opportunity to enjoy a control premium.286 The
Court held that the corporation was not for sale because no active bidding process was initiated
and the merger was not a change in control and, therefore, that enhanced scrutiny of the board’s
approval of the merger was not appropriate.287 Citing QVC, the Court stated that “there is no
‘sale or change in control’ when ‘[c]ontrol of both [corporations] remain[s] in a large, fluid,
changeable and changing market.’”288 As continuing shareholders in Bank of Boston, the former
Bancorp shareholders retained the opportunity to receive a control premium.289 The Court noted
that in QVC a single person would have control of the resulting corporation, effectively
eliminating the opportunity for shareholders to realize a control premium.290
282
283
284
285
286
287
288
289
290
QVC, 637 A.2d at 43 (footnote omitted).
634 A.2d 345 (Del. 1993).
Id. at 361.
650 A.2d 1270, 1273 (Del. 1994).
Id. at 1289.
Id. at 1289-90.
Id. at 1290.
Id.
Id.; see also Paramount Communications, Inc. v. Time, Inc., 571 A.2d 1140 (Del. 1989).
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3.
Entire Fairness.
Both the business judgment rule and the enhanced scrutiny standard should be contrasted
with the “entire fairness” standard applied in transactions with affiliates.291 In reviewing board
action in transactions involving management, board members or a principal shareholder, the
Delaware Supreme Court has imposed an “entire fairness” standard.292 Under this standard the
burden is on directors to show both (i) fair dealing and (ii) a fair price:
The former embraces questions of when the transaction was timed, how it was
initiated, structured, negotiated, disclosed to the directors, and how the approvals
of the directors and the stockholders were obtained. The latter aspect of fairness
relates to the economic and financial considerations of the proposed merger,
including all relevant factors: assets, market value, earnings, future prospects,
and any other elements that affect the intrinsic or inherent value of a company’s
stock.293
The burden shifts to the challenger to show the transaction was unfair where (i) the transaction is
approved by the majority of the minority shareholders, though the burden remains on the
directors to show that they completely disclosed all material facts relevant to the transaction,294
or (ii) the transaction is negotiated by a special committee of independent directors that is truly
independent, not coerced and has real bargaining power.295
C.
Action Without Bright Lines.
Whether the burden will be on the party challenging board action, under the business
judgment rule, or on the directors, under enhanced scrutiny, clearly the care with which the
directors acted in a change of control transaction will be subjected to close review. For this
review there will be no “bright line” tests, and it may be assumed that the board may be called
upon to show care commensurate with the importance of the decisions made, whatever they may
have been in the circumstances. Thus directors, and counsel advising them, should heed the
Delaware Supreme Court in Barkan v. Amsted Indus., Inc.:296 “[T]here is no single blueprint that
a board must follow to fulfill its duties. A stereotypical approach to the sale and acquisition of
corporate control is not to be expected in the face of the evolving techniques and financing
devices employed in today’s corporate environment.” In the absence of bright lines and
blueprints that fit all cases, the process to be followed by the directors will be paramount. The
elements of the process should be clearly understood at the beginning, and the process should be
guided and well documented by counsel throughout.
291
292
293
294
295
296
Directors also will have the burden to prove the entire fairness of the transaction to the corporation and its stockholders
if a stockholder plaintiff successfully rebuts the presumption of valid business judgment. Aronson v. Lewis, 473 A.2d
at 811-12.
See Weinberger v. UOP, Inc., 457 A.2d 701, 710-11 (Del. 1983); Mills Acquisition Co. v. Macmillan, Inc., 559 A.2d
1261 (Del. 1988).
Weinberger, 457 A.2d at 711.
Id at 703.
See Kahn v. Lynch Communications Sys., Inc., 638 A.2d 1110, 1117 (Del. 1994).
567 A.2d 1279, 1286 (Del. 1989).
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VI.
M&A Transaction Process.
A.
Statutory Framework: Board and Shareholder Action.
Both Texas and Delaware law permit corporations to merge with other corporations by
adopting a plan of merger and obtaining the requisite shareholder approval.297 Under Texas law,
approval of a merger will generally require approval of the holders of at least two-thirds of the
outstanding shares entitled to vote on the merger, while Delaware law provides that mergers may
be approved by a vote of the holders of a majority of the outstanding shares.298 As with other
transactions, the Texas Corporate Statues permit a corporation’s certificate of formation to
reduce the required vote to an affirmative vote of the holders of a majority of the outstanding
shares.299
Both Texas and Delaware permit a merger to be effected without shareholder approval if
the corporation is the sole surviving corporation, the shares of stock of the corporation are not
changed as a result of the merger and the total number of shares of stock issued pursuant to the
merger does not exceed 20% of the shares of the corporation outstanding immediately prior to
the merger.300
Board action on a plan of merger is required under both Texas and Delaware law.
However, Texas law does not require that the board of directors approve the plan of merger, but
rather it need only adopt a resolution directing the submission of the plan of merger to the
corporation’s shareholders.301 Such a resolution must either recommend that the plan of merger
be approved or communicate the basis for the board’s determination that the plan be submitted to
shareholders without any recommendation.302 The Texas Corporate Statues’ allowance of
directors to submit a plan of merger to shareholders without recommendation is intended to
address those few circumstances in which a board may consider it appropriate for shareholders to
be given the right to vote on a plan of merger but for fiduciary or other reasons the board has
concluded that it would not be appropriate for the board to make a recommendation.303
Delaware law has no similar provision and requires that the board approve the agreement of
merger and declare its advisability, and then submit the merger agreement to the stockholders for
the purpose of their adopting the agreement.304 Delaware and Texas permit a merger agreement
to contain a provision requiring that the agreement be submitted to the stockholders whether or
not the board of directors determines at any time subsequent to declaring its advisability that the
agreement is no longer advisable and recommends that the stockholders reject it.305
297
298
299
300
301
302
303
304
305
See TBOC §§ 10.001, 21.452; TBCA art. 5.01; DGCL §§ 251-58; see generally Curtis W. Huff, The New Texas
Business Corporation Act Merger Provisions, 21 ST. MARY’S L.J. 109 (1989).
TBOC §§ 21.452, 21.457; TBCA art. 5.03E; DGCL § 251(c).
TBOC § 21.365(a); TBCA art. 2.28.
TBOC § 21.459; TBCA art. 5.03G; DGCL § 251(f).
TBOC § 21.452(b)(2)(B); TBCA art. 5.03B(1).
TBOC § 21.452(d); TBCA art. 5.03B(1).
Byron F. Egan and Curtis W. Huff, Choice of State of Incorporation – Texas versus Delaware: Is It Now Time To
Rethink Traditional Notions?, 54 SMU L. Rev. 249, 282 (Winter 2001).
See DGCL § 251(b), (c).
DGCL § 146; TBOC §§ 21.452(f), (g); TBCA art. 5.01C(3).
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B.
Management’s Immediate Response.
Serious proposals for a business combination require serious consideration. The CEO
and management will usually be called upon to make an initial judgment as to seriousness. A
written, well developed proposal from a credible prospective acquiror should be studied. In
contrast, an oral proposal, or a written one that is incomplete in material respects, should not
require management efforts to develop the proposal further. In no event need management’s
response indicate any willingness to be acquired. In Citron v. Fairchild Camera and Instrument
Corp.,306 for example, the Delaware Supreme Court sanctioned behavior that included the CEO’s
informing an interested party that the corporation was not for sale, but that a written proposal, if
made, would be submitted to the board for review. Additionally, in Matador Capital
Management Corp. v. BRC Holdings, Inc.,307 the Delaware Chancery Court found unpersuasive
the plaintiff’s claims that the board failed to consider a potential bidder because the board’s
decision to terminate discussion was “justified by the embryonic state of [the potential bidder’s]
proposal.”308 In particular, the court stated that the potential bidder did not provide evidence of
any real financing capability and conditioned its offer of its ability to arrange the participation of
certain members of the target company’s management in the transaction.309
C.
The Board’s Consideration.
“When a board addresses a pending takeover bid it has an obligation to determine
whether the offer is in the best interests of the corporation and its shareholders.”310 Just as all
proposals are not alike, board responses to proposals may differ. A proposal that is incomplete
in material respects should not require serious board consideration. On the other hand, because
more developed proposals may present more of an opportunity for shareholders, they ought to
require more consideration by the board.311
1.
Matters Considered.
Where an offer is perceived as serious and substantial, an appropriate place for the board
to begin its consideration may be an informed understanding of the corporation’s value. This
may be advisable whether the board’s ultimate response is to “say no,” to refuse to remove preexisting defensive measures, to adopt new or different defensive measures or to pursue another
strategic course to maximize shareholder value. Such a point of departure is consistent with Van
306
307
308
309
310
311
569 A.2d 53 (Del. 1989).
729 A.2d 280 (Del. Ch. 1998).
Id. at 292.
Id.
Unocal, 493 A.2d at 954.
See Desert Partners, L.P. v. USG Corp., 686 F. Supp. 1289, 1300 (N.D. Ill. 1988) (applying Delaware law) (“The
Board did not breach its fiduciary duty by refusing to negotiate with Desert Partners to remove the coercive and
inadequate aspects of the offer. USG decided not to bargain over the terms of the offer because doing so would convey
the image to the market place ‘that (1) USG was for sale – when, in fact, it was not; and (2) $42/share was an ‘in the
ballpark’ price - when, in fact, it was not.’”); and Citron, 569 A.2d at 63, 66-67 (validating a board’s action in
approving one bid over another that, although higher on its face, lacked in specifics of its proposed back-end which
made the bid impossible to value). Compare Golden Cycle, LLC v. Allan, 1998 WL 892631, at *15-16 (Del. Ch.
December 10, 1998) (board not required to contact competing bidder for a higher bid before executing a merger
agreement where bidder had taken itself out of the board process, refused to sign a confidentiality agreement and
appealed directly to the stockholders with a consent solicitation).
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Gorkom and Unocal. In Van Gorkom, the board was found grossly negligent, among other
things, for not having an understanding of the intrinsic value of the corporation. In Unocal, the
inadequacy of price was recognized as a threat for which a proportionate response is
permitted.312
That is not to say, however, that a board must “price” the corporation whenever a suitor
appears. Moreover, it may be ill advised even to document a range of values for the corporation
before the conclusion of negotiations. However, should the decision be made to sell or should a
defensive reaction be challenged, the board will be well served to have been adequately informed
of intrinsic value during its deliberations from the beginning.313 In doing so, the board may also
establish, should it need to do so under enhanced scrutiny, that it acted at all times to maintain or
seek “the best value reasonably available to the stockholders.”314 This may also be advisable
even if that value derives from remaining independent.
There are, of course, factors other than value to be considered by the board in evaluating
an offer. The Delaware judicial guidance here comes from the sale context and the evaluation of
competing bids, but may be instructive:
In assessing the bid and the bidder’s responsibility, a board may consider, among
various proper factors, the adequacy and terms of the offer; its fairness and
feasibility; the proposed or actual financing for the offer, and the consequences of
that financing; questions of illegality; the impact of both the bid and the potential
acquisition on other constituencies, provided that it bears some reasonable
relationship to general shareholder interests; the risk of nonconsummation; the
basic stockholder interests at stake; the bidder’s identity, prior background and
other business venture experiences; and the bidder’s business plans for the
corporation and their effects on stockholder interests.315
2.
Being Adequately Informed.
Although there is no one blueprint for being adequately informed,316 the Delaware courts
do value expert advice, the judgment of directors who are independent and sophisticated, and an
active and orderly deliberation.
a.
Investment Banking Advice.
Addressing the value of a corporation generally entails obtaining investment banking
advice.
The analysis of value requires the “techniques or methods which are generally
317
312
313
314
315
316
317
Unocal, 493 A.2d at 955; see also Unitrin Inc. v. American Gen. Corp., 651 A.2d 1361, 1384 (Del. 1995), noting as a
threat “substantive coercion . . . the risk that shareholders will mistakenly accept an underpriced offer because they
disbelieve management’s representations of intrinsic value.”
See Technicolor, 634 A.2d at 368.
QVC, 637 A.2d at 45.
Macmillan, 559 A.2d at 1282 n.29 (citations omitted).
See Goodwin v. Live Entertainment, Inc., 1999 WL 64265, at *21 (Del. Ch. 1999) (citing Barkan, 567 A.2d at 1286).
See, e.g., In re Talley Indus., Inc. Shareholders Litig., 1998 WL 191939, at *11-12 (Del. Ch. 1998).
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considered acceptable in the financial community. . . .”318 Clearly, in Van Gorkom, the absence
of expert advice prior to the first Board consideration of a merger proposal contributed to the
determination that the Board “lacked valuation information adequate to reach an informed
business judgment as to the fairness [of the price]” and the finding that the directors were grossly
negligent.319 Although the Delaware Supreme Court noted that “fairness opinions by
independent investment bankers are [not] required as a matter of law,”320 in practice, investment
banking advice is typically obtained for a decision to sell and often for a decision not to sell. In
the non-sale context, such advice is particularly helpful where there may be subsequent pressure
to sell or disclosure concerning the board’s decision not to sell is likely. In either case, however,
the fact that the board of directors relies on expert advice to reach a decision provides strong
support that the Board acted reasonably.321
The advice of investment bankers is not, however, a substitute for the judgment of the
directors.322 As the court pointed out in Citron, “in change of control situations, sole reliance on
hired experts and management can ‘taint the design and execution of the transaction’.”323 In
addition, the timing, scope and diligence of the investment bankers may affect the outcome of
subsequent judicial scrutiny. The following cases, each of which involves a decision to sell,
nevertheless may be instructive for board deliberations concerning a transaction that does not
result in a sale decision:
(1)
In Weinberger,324 the Delaware Supreme Court held that the board’s approval of
an interested merger transaction did not meet the test of fairness.325 The fairness analysis
prepared by the investment bankers was criticized as “hurried” where due diligence was
conducted over a weekend and the price was slipped into the opinion by the banking partner
(who was also a director of the corporation) after a quick review of the assembled diligence on a
plane flight.326
(2)
In Macmillan,327 the court enjoined defensive measures adopted by the board,
including a lock-up and no-shop granted to an acquiror, to hinder competing bids from Mills.
The court questioned an investment bank’s conclusion that an $80 per share cash offer was
318
319
320
321
322
323
324
325
326
327
Weinberger, 457 A.2d at 713.
Van Gorkom, 488 A.2d at 878.
Id. at 876.
See Goodwin, 1999 WL 64265, at *22 (“The fact that the Board relied on expert advice in reaching its decision not to
look for other purchasers also supports the reasonableness of its efforts.”); In re Vitalink Communications Corp.
Shareholders Litig., 1991 WL 238816, at *12 (Del. Ch. 1991) (citations omitted) (board’s reliance on the advice of
investment bankers supported a finding that the board had a “reasonable basis” to conclude that it obtained the best
offer).
See In re IXC Communications, Inc. Shareholders Litigation, 1999 WL 1009174 (Del. Ch. 1999), in which Vice
Chancellor Steele stated that “[n]o board is obligated to heed the counsel of any of its advisors and with good reason.
Finding otherwise would establish a procedure by which this Court simply substitutes advise from Morgan Stanley or
Merrill Lynch for the business judgment of the board charged with ultimate responsibility for deciding the best interests
of shareholders.”
Citron, 569 A.2d at 66 (citation omitted).
Weinberger, 457 A.2d 701.
Id. at 715.
Id. at 712.
Macmillan, 559 A.2d 1261 (Del. 1988).
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inadequate when it had earlier opined that the value of the company was between $72 and $80
per share and faulted the investment bankers, who were retained by and consulted with
financially interested management, for lack of independence.328
(3)
In Technicolor,329 the court faulted the valuation package prepared by the
investment bankers because they were given limited access to senior officers and directors of
Technicolor.
Often all or part of the investment banker’s fee is payable only in the event of success in
the transaction. If there is a contingent component in the banker’s fee, the Board should
recognize the possible effect of that incentive and, if a transaction is ultimately submitted for
shareholder vote, include information about the contingent element among the disclosures to
shareholders.330
b.
Value of Independent Directors, Special Committees.
One of the first tasks of counsel in a takeover context is to assess the independence of the
Board.331 In a sale of control transaction, “the role of outside, independent directors becomes
particularly important because of the magnitude of a sale of control transaction and the
possibility, in certain cases, that management may not necessarily be impartial.”332 As pointed
out by the Delaware Supreme Court in Unocal, when enhanced scrutiny is applied by the court,
“proof is materially enhanced . . . by the approval of a board comprised of a majority of outside
independent directors who have acted [in good faith and after a reasonable investigation].”333
(1)
Characteristics of an Independent Director. An independent director has been
defined as a non-employee and non-management director.334 To be effective, outside directors
cannot be dominated by financially interested members of management or a controlling
stockholder.335 Care should also be taken to restrict the influence of other interested directors,
328
329
330
331
332
333
334
335
Id. at 1271.
Technicolor, 634 A.2d 345.
In Louisiana Municipal Police Employees’ Retirement System v. Crawford, 2007 WL 582510 (Del. Ch. Feb. 23, 2007)
and Express Scripts, Inc. v. Crawford, 2007 WL 707550 (Del. Ch. Feb. 23, 2007), the Court of Chancery held that a
postponement of the stockholder vote was necessary to provide the target stockholders with additional disclosure that
the major part of the financial advisors’ fee was contingent upon the consummation of a transaction by target with its
merger partner or a third party. The target’s proxy statement disclosure was found misleading because it did not clearly
state that its financial advisors were entitled to the fee only if the initial merger was approved. The Court concluded
that disclosure of these financial incentives to the financial advisors was material to the stockholder deliberations on the
merger.
See, e.g., Kahn v. MSB Bancorp, Inc., 1998 WL 409355, at *3 (Del. Ch. 1998), aff’d 734 A.2d 158 (Del. 1999) (“[T]he
fact that nine of the ten directors are not employed by MSB, but are outside directors, strengthens the presumption of
good faith.”)
QVC, 637 A.2d at 44; see also Macmillan, 559 A.2d 1261.
Unocal, 493 A.2d at 955.
Unitrin, 651 A.2d at 1375; see notes 131-146 and related text, supra.
See Macmillan, 559 A.2d at 1266.
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which may include recusal of interested directors from participation in certain board
deliberations.336
(2)
Need for Active Participation. Active participation of the independent members
of the board is important in demonstrating that the Board did not simply follow management. In
Time,337 the Delaware Supreme Court considered Time’s actions in recasting its previously
negotiated merger with Warner into an outright cash and securities acquisition of Warner
financed with significant debt to ward off Paramount’s surprise all-cash offer to acquire Time.
Beginning immediately after Paramount announced its bid, the Time board met repeatedly to
discuss the bid, determined the merger with Warner to be a better course of action, and declined
to open negotiations with Paramount. The outside directors met independently, and the Board
sought advice from corporate counsel and financial advisors. Through this process the Board
reached its decision to restructure the combination with Warner. The Court viewed favorably the
participation of certain of the Board’s 12 independent directors in the analysis of Paramount’s
bid. The Time Board’s process contrasts with Van Gorkom, where although one-half of Trans
Union’s Board was independent, an absence of any inquiry by those directors as to the basis of
management’s analysis and no review of the transaction documents contributed to the court’s
finding that the board was grossly negligent in its decision to approve a merger.338
(3)
Use of Special Committee. When directors or shareholders with fiduciary
obligations have a conflict of interest with respect to a proposed transaction, the use of a special
committee is recommended. A special committee is also recommended where there is the
potential for a conflict to develop.339 Accordingly, use of a special committee should be
considered in connection with any going-private transaction (i.e., management buy-outs or
squeeze-out mergers), asset sales or acquisitions involving entities controlled by or affiliated
with directors or controlling shareholders, or any other transactions with majority or controlling
shareholders.340 If a majority of the Board is disinterested and independent with respect to a
336
337
338
339
340
See Technicolor, 634 A.2d at 366 n.35. See also Brehm v. Eisner, 746 A.2d 244, 256 (Del. 2000) (in evaluating charge
that directors breached fiduciary duties in approving employment and subsequent severance of a corporation’s
president, the Delaware Supreme Court held that the “issues of disinterestedness and independence” turn on whether
the directors were “incapable, due to personal interest or domination and control, of objectively evaluating” an action).
571 A.2d 1140 (Del. 1989).
See also Kahn v. Tremont Corp., 694 A.2d 422, 429 (Del. 1997), where the Delaware Supreme Court found that the
three member special committee of outside directors was not fully informed, not active, and did not appropriately
simulate an arm’s-length transaction, given that two of the three members permitted the other member to perform the
committee’s essential functions and one of the committee members did not attend a single meeting of the committee.
See In re Western National Corp. Shareholders Litig., 2000 WL 710192 at *26 (Del. Ch. May 22, 2000)(use of special
committee where the transaction involved a 46% stockholder; court ultimately held that because the 46% stockholder
was not a controlling stockholder, the business judgment rule would apply: “[w]ith the aid of its expert advisors, the
Committee apprised itself of all reasonably available information, negotiated ... at arm’s length and, ultimately,
determined that the merger transaction was in the interests of the Company and its public shareholders”).
See In re Digex, Inc. Shareholders Litig., 789 A.2d 1176 (Del. Ch. 2000) (special committee of a company with a
controlling corporate shareholder formed to consider potential acquisition offers); Kohls v. Duthie, 765 A.2d 1274,
1285 (Del. Ch. 2000)(special committee formed in connection with a management buyout transaction); T. Rowe Price
Recovery Fund, L.P. v. Rubin, 770 A.2d 536 (Del. Ch. 2000) (special committee used to consider shared service
agreements among corporation and its chief competitor, both of which were controlled by the same entity); In re
MAXXAM, Inc./Federated Development Shareholders Litig., 1997 Del. Ch. LEXIS 51 (Del. Ch. Apr. 4, 1997) (special
committee formed to consider a purchase of assets from the controlling stockholder); Citron v. E.I. Du Pont de
Nemours & Co., 584 A.2d 490 (Del. Ch. 1990) (majority shareholder purchase of minority shares); Lynch I (involving
controlling shareholder’s offer to purchase publicly held shares); In re Resorts International Shareholders Litig., 570
A.2d 259 (Del. 1990) (special committee used to evaluate controlling shareholder’s tender offer and competing tender
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proposed transaction (other than a freeze out merger proposal by a controlling stockholder), a
special committee may not be necessary, since the Board’s decision will be accorded deference
under the business judgment rule (assuming, of course, that the disinterested directors are not
dominated or otherwise controlled by the interested party(ies)). In that circumstance, the
disinterested directors may act on behalf of the company and the interested directors should
abstain from deliberating and voting on the proposed transaction.341
Although there is no legal requirement under Delaware law that an interested Board make
use of a special committee, the Delaware courts have indicated that the absence of such a
committee in connection with an affiliate or conflict transaction may evidence the transaction’s
unfairness (or other procedural safeguards, such as a majority of mino`rity vote requirement).342
(i)
Formation of the Committee
Where a majority of the Board is disinterested, a special committee may be useful if there
are reasons to isolate the deliberations of the noninterested directors.343 Where a majority of the
directors have some real or perceived conflict, however, and in the absence of any other
procedural safeguards, the formation of a special committee is critical. Ideally, the special
committee should be formed prior to the first series of negotiations of a proposed transaction, or
immediately upon receipt of an unsolicited merger or acquisition proposal. Formation at a later
stage is acceptable, however, if the special committee is still capable of influencing and
ultimately rejecting the proposed transaction.344 As a general rule, however, the special
341
342
343
344
offer); Kahn v. Sullivan, 594 A.2d 48, 53 (Del. 1991) (special committee formed to evaluate corporation’s charitable
gift to entity affiliated with the company’s chairman and CEO); Kahn v. Dairy Mart Convenience Stores, Inc., 1996
Del. Ch. LEXIS 38, at *18-19 (Del. Ch. March 29, 1996) (special committee formed to consider management LBO);
Kahn v. Roberts, 679 A.2d 460, 465 (Del. 1996) (special committee formed to evaluate stock repurchase from 33%
shareholder).
See DGCL § 144 (providing that interested director transactions will not be void or voidable solely due to the existence
of the conflict if certain safeguards are utilized, including approval by a majority of the disinterested directors,
assuming full disclosure).
See Seagraves v. Urstady Property Co., 1996 Del. Ch. LEXIS 36, at *16 (Del. Ch. Apr. 1, 1996) (failure to use a
special committee or other procedural safeguards “evidences the absence of fair dealing”); Jedwab v. MGM Grand
Hotels, Inc., 509 A.2d 584, 599 (Del. Ch. 1986) (lack of independent committee is pertinent factor in assessing whether
fairness was accorded to the minority); Boyer v. Wilmington Materials, Inc., 1997 Del. Ch. LEXIS 97, at *20 (Del. Ch.
June 27, 1997) (lack of special committee is an important factor in a court’s “overall assessment of whether a
transaction was fair”).
See Spiegal v. Buntrock, 571 A.2d 767, 776 n.18 (Del. 1990) (“Even when a majority of a board of directors is
independent, one advantage of establishing a special negotiating committee is to isolate the interested directors from
material information during either the investigative or decisional process”); Moore Business Forms, Inc. v. Cordant
Holdings Corp., 1996 Del. Ch. LEXIS 56, at *18-19 (Del. Ch. June 4, 1996) (recommending use of a special
committee to prevent shareholder’s board designee’s access to privileged information regarding possible repurchase of
shareholder’s preferred stock; “the special committee would have been free to retain separate legal counsel, and its
communications with that counsel would have been properly protected from disclosure to [the shareholder] and its
director designee”); Kohls v. Duthie, 765 A.2d at 1285 (forming a special committee to isolate the negotiations of the
noninterested directors from one director that would participate in a management buyout).
See In re SS&C Technologies, Inc. Shareholder Litigation, 911 A.2d 816 (Del. Ch. 2006), a case in which the
settlement of litigation challenging a management led cash-out merger was disapproved in part because he Court was
concerned that the buyer’s proposal was solicited by the CEO without prior Board approval as part of informal “test the
waters” process to find a buyer who would pay a meaningful premium while allowing the CEO to make significant
investment in the acquisition vehicle and continue managing the target. After being satisfied with the buyer’s proposal
but before all details had been negotiated, the CEO advised the Board about the deal. The Board then formed special
committee that hired independent legal and financial advisers and embarked on a program to solicit other buyers, but
the Court was concerned that this process was perhaps too late to affect outcome. The Court expressed concern
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committee should be formed whenever the conflicts of fellow directors become apparent in light
of a proposed or contemplated transaction. To the extent possible, however, the controlling
stockholder or the CEO, if interested, should not select, or influence the selection of, the
members of the special committee or its chairperson.345
(ii)
Independence and Disinterestedness
In selecting the members of a special committee, care should be taken to ensure not only
that the members have no financial interest in the transaction, but that they have no financial ties,
or are otherwise beholden, to any person or entity involved in the transaction.346 In other words,
all committee members should be independent and disinterested. To be disinterested, the member
cannot derive any personal (primarily financial) benefit from the transaction not shared by the
stockholders.347 To be independent, the member’s decisions must be “based on the corporate
merits of the subject before the [committee] rather than extraneous considerations or
influences.”348 To establish non-independence, a plaintiff has to show that the committee
members were “beholden” to the conflicted party or “so under [the conflicted party’s] influence
that their discretion would be sterilized.”349 In a recent case in which committee members
appeared to abdicate their responsibilities to another member “whose independence was most
suspect,” the Delaware Supreme Court reemphasized that:
“[i]t is the care, attention and sense of individual responsibility to the performance
of one’s duties...that generally touches on independence.”350
If a committee member votes to approve a transaction to appease the interested
director/shareholder, to stay in the interested party’s good graces, or because he/she is beholden
345
346
347
348
349
350
whether the CEO had misused confidential information and resources of corporation in talking to his selected buyer
and engaging an investment banker before Board approval and whether the CEO’s precommitment to a deal with the
buyer and his conflicts (i.e., receiving cash plus an interest in the acquisition vehicle and continuing management role)
prevented the Board from considering whether a sale should take place and, if so, to negotiating the best terms
reasonably available. See Note 593 and related text.
See Macmillan, 559 A.2d at 1267 (in case where special committee had no burden-shifting effect, court noted that the
interested CEO “hand picked” the members of the committee); In re Fort Howard Corp. Shareholders Litig., 1988 WL
83147 (Del. Ch. 1988) (“It cannot ... be the best practice to have the interested CEO in effect handpick the members of
the Special Committee as was, I am satisfied, done here.”).
See Katell v. Morgan Stanley Group, Inc., 1995 Del. Ch. LEXIS 76, at * 21, Fed. Sec. L. Rep. (CCH) 98861 (Del. Ch.
June 15, 1995) (“[w]hen a special committee’s members have no personal interest in the disputed transactions, this
Court scrutinizes the members’ relationship with the interested directors”); E. Norman Veasey, Duty of Loyalty: The
Criticality of the Counselor’s Role, 45 Bus. Law. 2065, 2079 (“the members of the committee should not have
unusually close personal or business relations with the conflicted directors”).
Pogostin v. Rice, 480 A.2d 619, 624, 627 (Del. 1984) (overruled as to standard of appellate review).
Aronson, 473 A.2d at 816; In re MAXXAM, Inc./Federated Development Shareholders Litig., 659 A.2d 760, 773 (Del.
Ch. 1995) (“To be considered independent, a director must not be ‘dominated or controlled by an individual or entity
interested in the transaction.’“ (citing Grobow v. Perot, 539 A.2d 180, 189 (Del. 1988) (overruled as to standard of
appellate review)). See also Grimes v. Donald, 673 A.2d 1207, 1219 n.25 (Del. 1996) (parenthetically describing
Lynch I as a case in which the “‘independent committee’ of the board did not act independently when it succumbed to
threat of controlling stockholder”) (overruled as to standard of appellate review).
MAXXAM, 659 A.2d at 773 (quoting Rales v. Blasband, 634 A.2d 927, 936 (Del. 1993)).
Kahn v. Tremont Corp., 694 A.2d 422, 430 (Del. 1997) (citing Aronson, 473 A.2d at 816).
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to the interested party for the continued receipt of consulting fees or other payments, such
committee member will not be viewed as independent.351
(iii)
Selection of Legal and Financial Advisors
Although there is no legal requirement that a special committee retain legal and financial
advisors, it is highly advisable that the committee retain advisors to help them carry out their
duties.352 The selection of advisors, however, may influence a court’s determinations of the
independence of the committee and the effectiveness of the process.353
Selection of advisors should be made by the committee after its formation. Although the
special committee may rely on the company’s professional advisors, perception of the special
committee’s independence is enhanced by the separate retention of advisors who have no prior
affiliation with the company or interested parties.354 Accordingly, the special committee should
take time to ensure that its professional advisors have no prior or current, direct or indirect,
material affiliations with interested parties.
Retention of legal and financial advisors by the special committee also enhances its
ability to be fully informed. Because of the short time-frame of many of today’s transactions,
professional advisors allow the committee to assimilate large amounts of information more
quickly and effectively than the committee could without advisors. Having advisors that can
efficiently process and condense information is important where the committee is asked to
evaluate proposals or competing proposals within days of their making.355 Finally, a court will
351
352
353
354
355
Rales, 634 A.2d at 936-37; MAXXAM, Inc./Federated Development Shareholders Litig., 1997 Del. Ch. LEXIS 51, at
*66-71 (Del. Ch. Apr. 4, 1997) (special committee members would not be considered independent due to their receipt
of consulting fees or other compensation from entities controlled by the shareholder who controlled the company);
Kahn v. Tremont Corp., 694 A.2d at 429-30 (holding that special committee “did not function independently” because
the members had “previous affiliations with [an indirect controlling shareholder, Simmons,] or companies which he
controlled and, as a result, received significant financial compensation or influential positions on the boards of
Simmons’ controlled companies.”); Kahn v. Dairy Mart Convenience Stores, Inc., 1996 Del. Ch. LEXIS 38, at *18-19
(noting that the special committee member was also a paid consultant for the corporation, raising concerns that he was
beholden to the controlling shareholder).
See, e.g., Strassburger v. Earley, 752 A.2d 557, 567 (Del. Ch. 2000)(court criticizing a one-man special committee and
finding it ineffective in part because it had not been “advised by independent legal counsel or even an experienced
investment banking firm”).
See Kahn v. Dairy Mart Convenience Stores, Inc., 1996 Del. Ch. LEXIS 38, at *22 n.6 (a “critical factor in assessing
the reliability and independence of the process employed by a special committee, is the committee’s financial and legal
advisors and how they were selected”); In re Fort Howard Corp. Shareholders Litig., 1988 WL 83147 (Del. Ch. 1988)
(“no role is more critical with respect to protection of shareholder interests in these matters than that of the expert
lawyers who guide sometimes inexperienced [committee members] through the process”). See note 376 and related
text, infra.
See, e.g., Citron v. E.I. Du Pont de Nemours & Co., 584 A.2d at 494 (noting that to insure a completely independent
review of a majority stockholder’s proposal the independent committee retained its own independent counsel rather
than allowing management of the company to retain counsel on its behalf); cf. In re Fort Howard, 1988 WL 83147
(Del. Ch. 1988) (noting that the interested CEO had selected the committee’s legal counsel; “[a] suspicious mind is
made uneasy contemplating the possibilities when the interested CEO is so active in choosing his adversary”);
Macmillan, 559 A.2d at 1267-68 (noting that conflicted management, in connection with an MBO transaction, had
“intensive contact” with a financial advisor that subsequently was selected by management to advise the special
committee).
See, e.g., In re KDI Corp. Shareholders Litig., 1990 Del. Ch. LEXIS 201, at *10, Fed. Sec. L. Rep. (CCH) 95727 (Del.
Ch. Dec. 13, 1990) (noting that special committee’s financial advisor contacted approximately 100 potential purchasers
in addition to evaluating fairness of management’s proposal).
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give some deference to the committee’s selection of advisors where there is no indication that
they were retained for an “improper purpose.”356
(iv)
The Special Committee’s Charge: “Real Bargaining Power”
From a litigation standpoint, one of the most important documents when defending a
transaction that has utilized a special committee is the board resolution authorizing the special
committee and describing the scope of its authority.357 Obviously, if the board has materially
limited the special committee’s authority, the work of the special committee will not be given
great deference in litigation since the conflicted board will be viewed as having retained ultimate
control over the process.358 Where, however, the special committee is given broad authority and
permitted to negotiate the best possible transaction, the special committee’s work and business
decisions will be accorded substantial deference.359
The requisite power of a special committee was addressed initially in Rabkin v. Olin
Corp.
In Rabkin, the court noted that the “mere existence of an independent special
committee” does not itself shift the burden of proof with respect to the entire fairness standard of
review. Rather, the court stated that at least two factors are required:
360
First, the majority shareholder must not dictate the terms of the merger. Second,
the special committee must have real bargaining power that it can exercise with
the majority shareholder on an arms length basis. The Hunt special committee
was given the narrow mandate of determining the monetary fairness of a nonnegotiable offer. [The majority shareholder] dictated the terms of the merger and
there were no arm’s length negotiations. Unanimous approval by the apparently
independent Hunt board suffers from the same infirmities as the special
committee. The ultimate burden of showing by a preponderance of the evidence
that the merger was entirely fair thus remains with the defendants.361
356
357
358
359
360
361
See Clements v. Rogers, 790 A.2d 1222 (Del. Ch. 2001) (court brushing aside criticism of choice of local banker where
there was valid business reasons for the selection).
See, e.g., In re Digex, Inc. Shareholders Litig., 789 A.2d 1176 (Del. Ch. 2000) (quoting board resolution which
described the special committee’s role); Strassburger, 752 A.2d at 567 (quoting the board resolution authorizing the
special committee); Kahn v. Sullivan, 594 A.2d at 53 (quoting in full the board resolutions creating the special
committee and describing its authority).
See, e.g., Strassburger, 752 A.2d at 571 (court noting that the “narrow scope” of the committee’s assignment was
“highly significant” to its finding that the committee was ineffective and would not shift the burden of proof).
Compare Kohls v. Duthie, 765 A.2d at 1285 (noting the bargaining power, active negotiations and frequent meetings of
the special committee and concluding that the special committee process was effective and that defendants would likely
prevail at a final hearing) with International Telecharge, Inc. v. Bomarko, Inc., 766 A.2d 437 (Del. 2000) (affirming the
trial court’s application of the entire fairness standard where the special committee was misinformed and did not
engage in meaningful negotiations).
1990 Del. Ch. LEXIS 50, at *18, Fed. Sec. L. Rep. (CCH) 95255 (Del. Ch. Apr. 17, 1990), reprinted in 16 Del. J. Corp.
L. 851 (1991), aff’d, 586 A.2d 1202 (Del. 1990) (“Rabkin“).
Rabkin, 1990 Del. Ch. LEXIS 50, at *18-19 (citations omitted); see also Kahn v. Lynch Comm. Systems, Inc., 669 A.2d
79, 82-83 (Del. 1995) (“Lynch II”) (noting the Supreme Court’s approval of the Rabkin two-part test).
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Even when a committee is active, aggressive and informed, its approval of a transaction
will not shift the entire fairness burden of persuasion unless the committee is free to reject the
proposed transaction.362 As the court emphasized in Lynch I:
The power to say no is a significant power. It is the duty of directors serving on
[an independent] committee to approve only a transaction that is in the best
interests of the public shareholders, to say no to any transaction that is not fair to
those shareholders and is not the best transaction available. It is not sufficient for
such directors to achieve the best price that a fiduciary will pay if that price is not
a fair price.363
Accordingly, unless the interested party can demonstrate it has “replicated a process ‘as
though each of the contending parties had in fact exerted its bargaining power at arm’s length,’
the burden of proving entire fairness will not shift.”364
Importantly, if there is any change in the responsibilities of the committee due to, for
example, changed circumstances, the authorizing resolution should be amended or otherwise
supplemented to reflect the new charge.365
(v)
Informed and Active
A committee with real bargaining power will not cause the burden of persuasion to shift
unless the committee exercises that power in an informed and active manner.366 The concepts of
being active and being informed are interrelated. An informed committee will almost necessarily
be active and vice versa.367
To be informed, the committee necessarily must be knowledgeable with respect to the
company’s business and advised of, or involved in, ongoing negotiations. To be active, the
committee members should be involved in the negotiations or at least communicating frequently
362
363
364
365
366
367
Kahn v. Lynch Comm. Systems, Inc., 638 A.2d at 1120-21 (“Lynch I”) (“[p]articular consideration must be given to
evidence of whether the special committee was truly independent, fully informed, and had the freedom to negotiate at
arm’s length”); see also In re First Boston, Inc. Shareholders Litig., 1990 Del. Ch. LEXIS 74, at *20, Fed. Sec. L. Rep.
(CCH) 95322 (Del. Ch. June 7, 1990) (holding that although special committee’s options were limited, it retained “the
critical power: the power to say no”).
Lynch I, 638 A.2d at 1119 (quoting In re First Boston, Inc. Shareholders Litig., 1990 Del. Ch. LEXIS 74, at *20-21,
Fed. Sec. L. Rep. (CCH) 95322 (Del. Ch. June 7, 1990)).
Lynch I, 638 A.2d at 1121 (quoting Weinberger, 457 A.2d at 709-710 n.7). See also In re Digex, Inc. Shareholders
Litig., 789 A.2d 1176 (Del. Ch. 2000) (inability of special committee to exercise real bargaining power concerning
Section 203 issues is fatal to the process).
See, e.g., In re Resorts International Shareholders Litig., 570 A.2d 259 (Del. 1990) (where special committee initially
considered controlling shareholder’s tender offer and subsequently a competing tender offer and proposed settlements
of litigation resulting from offers); Lynch I, 638 A.2d at 1113 (noting that the board “revised the mandate of the
Independent Committee” in light of tender offer by controlling stockholder).
See, e.g., Kahn v. Dairy Mart Convenience Stores, Inc., 1996 Del. Ch. LEXIS 38, at *7 (Del. Ch. March 29, 1996)
(despite being advised that its duty was “to seek the best result for the shareholders, the committee never negotiated for
a price higher than $15”); Strassburger, 752 A.2d at 567 (finding a special committee ineffective where it did not
engage in negotiations and “did not consider all information highly relevant to [the] assignment”); Clements v. Rogers,
790 A.2d 1222 (Del. Ch. 2001) (court criticizing a special committee for failing to fully understand the scope of the
committee’s assignment).
Kahn v. Tremont Corp., 694 A.2d at 430.
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with the designated negotiator. In addition, the members should meet frequently with their
independent advisors so that they can acquire “critical knowledge of essential aspects of the
[transaction].”368
Committee members need to rely upon, interact with, and challenge their financial and
legal advisors. While reliance is often important and necessary, the committee should not allow
an advisor to assume the role of ultimate decision-maker. For example, in In re Trans World
Airlines, Inc. Shareholders Litig., the court determined, in connection with a preliminary
injunction application, that substantial questions were raised as to the effectiveness of a special
committee where the committee misunderstood its role and “relied almost completely upon the
efforts of [its financial advisor], both with respect to the evaluation of the fairness of the price
offered and with respect to such negotiations as occurred.”369
Similarly, in Mills Acquisition Co. v. MacMillan, Inc.,370 the court criticized the
independent directors for failing to diligently oversee an auction process conducted by the
company’s investment advisor that indirectly involved members of management. In this regard,
the court stated:
Without board planning and oversight to insulate the self-interested management
from improper access to the bidding process, and to ensure the proper conduct of
the auction by truly independent advisors selected by, and answerable only to, the
independent directors, the legal complications which a challenged transaction
faces under [enhanced judicial scrutiny] are unnecessarily intensified.371
c.
Significant Recent Process Cases.
(1)
In re Tele-Communications, Inc. Shareholders Litig.,372 the Chancery Court
denied defendants motion for summary judgment on several claims arising out of the 1999
merger of Tele-Communications, Inc. (“TCI”) with AT&T Corp in large part because the
defendants failed to adequately show that a special committee of the TCI board of directors
formed to consider the merger proposal was truly independent, fully informed and had the
freedom to negotiate at arm’s length in a manner sufficient to shift the burden of proving entire
fairness of a transaction providing a premium to a class or series of high-vote stock over a class
or series of low-vote stock. Citing FLS Holdings373 and Reader’s Digest,374 the Chancery Court
in Tele-Communications found that entire fairness should apply because “a clear and significant
benefit . . . accrued primarily . . . to directors controlling a large vote of the corporation, at the
368
369
370
371
372
373
374
Id. at 429-430 (committee member’s “absence from all meetings with advisors or fellow committee members, rendered
him ill-suited as a defender of the interests of minority shareholders in the dynamics of fast moving negotiations”). See
also Macmillan, 559 A.2d at 1268 n.9 (in case where special committee had no burden-shifting effect, court noted that
one committee member “failed to attend a single meeting of the Committee”); Strassburger, 752 A.2d at 557 (finding
an ineffective committee where its sole member did not engage in negotiations and had less than complete
information).
1988 Del. Ch. LEXIS 139, at *12, *22 (Del. Ch. Oct. 21, 1988) reprinted in 14 Del. J. Corp. L. 870 (1989).
559 A.2d at 1281.
Id. at 1282.
C.A. No. 16470, Chandler, C. (Del. Ch. Dec. 21, 2005, revised January 10, 2006).
In re FLS Holdings, Inc. S’holders Litig., 1993 WL 104562 (Del. Ch. Apr. 21, 1993).
Levco Alternative Fund Ltd. v. Reader’s Digest Ass’n, Inc., 803 A.2d 428 (Del. 2002).
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expense of another class of shareholders to whom was owed a fiduciary duty.”375 Alternatively,
the Court concluded that a majority of the TCI directors were interested in the transaction
because they each received a material benefit from the premium accorded to the high vote shares.
In reaching the decision that the defendants failed to demonstrate fair dealing and fair
price, the Chancery Court found, based on a review of the evidence in a light most favorable to
the plaintiffs, the following special committee process flaws:
•
The Choice of Special Committee Directors. The special committee consisted of two
directors, one of whom held high vote shares and gained an additional $1.4 million as
result of the premium paid on those shares, to serve on the special committee. This flaw
appears to be of particular importance to the Court’s decision and contributed to the other
flaws in the committee process.
•
The Lack of a Clear Mandate. One committee member believed the special committee’s
job was to represent the interests of the holders of the low vote shares, while the other
member believed the special committee’s job was to protect the interests of all of the
stockholders.
•
The Choice of Advisors. The special committee did not retain separate legal and financial
advisors, and chose to use the TCI advisors. Moreover, the Court criticized the
contingent nature of the fee paid to the financial advisors, which amounted to
approximately $40 million, finding that such a fee created “a serious issue of material
fact, as to whether [the financial advisors] could provide independent advice to the
Special Committee.” While it agreed with TCI’s assertion that TCI had no interest in
paying advisor fees absent a deal, the Court wrote:
A special committee does have an interest in bearing the upfront
cost of an independent and objective financial advisor. A
contingently paid and possibly interested financial advisor might
be more convenient and cheaper absent a deal, but its potentially
misguided recommendations could result in even higher costs to
the special committee’s shareholder constituency in the event a
deal was consummated.
375
C.A. No. 16470, Chandler, C. (Del. Ch. Dec. 21, 2005, revised January 10, 2006); In re LNR Property Corp.
Shareholder Litigation (Del. Ch., Consolidated C.A. No. 674-N, November 4, 2005), in which the Chancery Court held
that minority shareholders who were cashed out in a merger negotiated by the controlling shareholder – who also ended
up with a 20 percent stake in the purchaser – stated allegations sufficient to warrant application of the entire-fairness
standard of review and wrote: “When a controlling shareholder stands on both sides of a transaction, he or she is
required to demonstrate his or her utmost good faith and most scrupulous inherent fairness of the bargain.” The
shareholders further alleged that LNR’s board of directors breached its fiduciary duties by allowing the controlling
stockholder and the CEO, who had “obvious and disabling conflicts of interest,” to negotiate the deal. Although the
board formed a special independent committee to consider the deal, plaintiffs alleged, the committee was a “sham”
because it was “dominated and controlled” by the controlling stockholder and the CEO, and was not permitted to
negotiate with the buyer or seek other deals. Additionally, the shareholders claimed that the committee failed to get an
independent evaluation of the deal, but relied on a financial advisor that worked with the controlling stockholder and
the CEO to negotiate the deal, and that stood to gain an $11 million commission when the transaction was completed.
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Since the advisors were hired to advise TCI in connection with the transaction, a question
arises as to whether the Court’s concerns about the contingent nature of the fee would
have been mitigated if a special committee comprised of clearly disinterested and
independent directors hired independent advisors and agreed to a contingent fee that
created appropriate incentives.
•
Diligence of Research and Fairness Opinion. The special committee lacked complete
information about the premium at which the high vote shares historically traded and
precedent transactions involving high vote stocks. The Court noted that the plaintiffs had
presented evidence that showed that the high vote shares had traded at a 10% premium or
more only for “a single five-trading day interval.” The Court did not find it persuasive
that the financial advisor supported the payment of the premium by reference to a call
option agreement between the TCI CEO and TCI that allowed TCI to purchase the TCI
CEO’s high vote shares for a 10% premium, expressing concern about the arm’s length
nature of that transaction. The Court stated that the special committee should have asked
the financial advisor for more information about the precedent transactions, including
information concerning the prevalence of the payment of a premium to high-vote stock
over low-vote stock. By contrast, the Court noted that the plaintiffs had presented
evidence suggesting that a significantly higher number of precedent transactions provided
no premium for high-vote stock, and neither the special committee nor its financial
advisors considered the fairness of the 10% premium paid on the high vote shares:
In the present transaction, the Special Committee failed to examine, and
[its financial advisors] failed to opine upon, the fairness of the [high vote]
premium to the [low vote] holders. [The financial advisors] provided only
separate analyses of the fairness of the respective exchange ratios to each
corresponding class. The [Reader’s Digest] Court mandated more than
separate analyses that blindly ignore the preferences another class might
be receiving, and with good intuitive reason: such a doctrine of separate
analyses would have allowed a fairness opinion in our case even if the
[high vote] holders enjoyed a 110% premium over the [low vote] holders,
as long as the [low vote] holders enjoyed a thirty-seven percent premium
over the market price. Entire fairness requires an examination of the
fairness of such exorbitant premiums to the prices received by the [low
vote] holders. This is not to say that the premium received by the [low
vote] holders is irrelevant—obviously, it must be balanced with the
fairness and magnitude of the 10% [high vote] premium.
•
Result is Lack of Arm’s Length Bargaining. All of the above factors led to a flawed
special committee process that created an “inhospitable” environment for arm’s length
bargaining. The Court found that the unclear mandate, the unspecified compensation
plan and the special committee’s lack of information regarding historical trading prices of
the high vote shares and the precedent merger transactions were relevant to concluding
that the process did not result in arm’s length bargaining.
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(2)
In Gesoff v. IIC Indus. Inc.,376 the Court of Chancery made clear that in evaluating
whether a going private transaction is entirely fair (or whether the burden of proving entire
fairness should be shifted to the plaintiff), it will examine the composition of, and the process
undertaken by, an independent committee closely for indicators of fairness. In Gesoff, the board
of CP Holdings Limited (“CP”), an English holding company owning approximately 80% of IIC
Industries Inc. (“IIC”), determined IIC should be taken private by way of a tender offer followed
by a short-form merger. The IIC board appointed a special committee consisting of one member,
and formally authorized him to present a recommendation to the IIC board as to the CP tender
offer. After some review, the one-person committee approved the tender offer transaction, but
the tender offer ultimately failed to provide CP with 90% of the outstanding stock, and CP
thereafter instituted a long-form merger. Although no new fairness opinion was sought for the
long-form merger, the special committee member supported the transaction. Following the
consummation of the transaction, minority stockholders sued, claiming the transaction was not
entirely fair and also seeking appraisal.
The Chancery Court evaluated the formation and actions of the special committee to
determine whether the process taken with regard to the tender offer and merger was entirely fair.
The Chancery Court stated that members of such a committee must be independent and willing
to perform their job throughout the entire negotiation, and further indicated that committees
should typically be composed of more than one director.
The Chancery Court also reiterated the importance of a committee’s mandate, stating that
a committee should have a clear understanding of its duties and powers, and should be given the
power not only to fully evaluate the transaction, but also to say “no” to the transaction. Although
the language of the resolution granting the committee member power in this case was fairly
broad (he was given the authority to appoint outside auditors and counsel, and was further
authorized to spend up to $100,000 for a fairness opinion), the Chancery Court stated that the
evidence indicated that his authority was closely circumscribed and that he was deeply confused
regarding the structure of the transaction.
The Chancery Court was also critical of the committee’s choice of financial and legal
advisors, as these advisors were essentially handpicked by CP and the conflicted IIC board. The
committee member accepted the appointment of a lawyer recommended by CP management who
also served as IIC’s outside counsel, was beholden for his job to a board dominated by CP, and
had been advising CP on the tender offer. The Chancery Court stated that no reasonable
observer would have believed that this attorney was appropriate independent counsel.
Evidence at trial showed that the investment bank retained by the independent committee
pitched itself to the committee member prior to his receipt of authority to hire advisors, and that
a member of CP’s management (who had a prior relationship with the banker) emailed the
banker saying he was close to having the bank “signed up” as an advisor to the committee. The
committee member, relying on advice of his conflicted legal counsel, then appointed the banker
without speaking to any other candidates for the position. Moreover, throughout negotiations,
the banker kept CP informed of all of the committee’s private valuations, essentially giving the
company the upper hand in negotiations. The Chancery Court was also particularly troubled by
376
C.A. Nos. 19473, 19600 (Del. Ch. May 18, 2006)
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an email between the committee’s lawyer and banker and CP’s management describing an
orchestrated negotiation process that foreshadowed the negotiation structure that eventually
occurred, and found this to be clear evidence that the negotiations were constructed by CP and
were thus not at arm’s-length.
Having found the process unfair, the Chancery Court then determined that the price paid
was also unfair, but found that the committee member was protected by the limitation of liability
provision found in IIC’s charter (as permitted by DGCL § 102(b)(7).
(3)
The importance of procedural safeguards was again emphasized in Oliver v.
Boston University,377 and in particular, the Court of Chancery focused on the lack of a
representative for the minority stockholders in merger negotiations. Boston University (“BU”)
was the controlling stockholder of Seragen, Inc. (“Seragen”), a financially troubled
biotechnology company. After going public in 1992, Seragen entered into a number of
transactions in order to address its desperate need for capital, and eventually agreed to a merger
with Ligand Pharmaceuticals, Inc. (“Ligand”). A group of minority stockholders brought a
series of claims challenging the transactions preceding the merger and the process by which the
merger proceeds were allocated to the respective classes.
The Chancery Court discussed whether the potential derivative claims arising from
various transactions preceding the merger were properly valued by the defendants in merger
negotiations. Noting that Seragen’s board effectively ignored these claims and that the
negotiations and approval of these transactions were procedurally flawed because no safeguards
were employed to protect the minority, the Court nonetheless found that these potential claims
had no actual value.
The Chancery Court then turned to whether the allocation of merger proceeds was
entirely fair, focusing on the company’s failure to take steps to protect the minority, and stated:
The Director Defendants treated the merger allocation negotiations with a
surprising degree of informality, and, as with many of Seragen’s transactions
reviewed here, no steps were taken to ensure fairness to the minority common
shareholders. More disturbing is that, although representatives of all of the
priority stakeholders were involved to some degree in the negotiations, no
representative negotiated on behalf of the minority common shareholders.…
Clearly the process implementing these negotiations was severely flawed and no
person acted to protect the interests of the minority common shareholders.
Although the derivative claims had been found to have no value, the Chancery Court held
that the allocation of merger proceeds was unfair due to both the lack of procedures to ensure its
fairness and because the price was also found to be unfair. After so holding, the Chancery Court
went on to dispose of the plaintiffs’ disclosure, voting power dilution, and aiding and abetting
claims.
377
C.A. No. 16570 (Del. Ch. Apr. 14, 2006)
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D.
Value of Thorough Deliberation.
The Delaware cases repeatedly emphasize the importance of the process followed by
directors in addressing a takeover proposal. The Delaware courts have frowned upon board
decision-making that is done hastily or without prior preparation. Counsel should be careful to
formulate and document a decision-making process that will withstand judicial review from this
perspective.
Early in the process the board should be advised by counsel as to the applicable legal
standards and the concerns expressed by the courts that are presented in similar circumstances.
Distribution of a memorandum from counsel can be particularly helpful in this regard.
Management should provide the latest financial and strategic information available concerning
the corporation and its prospects. If a sale is contemplated or the corporation may be put “in
play,” investment bankers should be retained to advise concerning comparable transactions and
market conditions, provide an evaluation of the proposal in accordance with current industry
standards, and, if requested, render a fairness opinion concerning the transaction before it is
finally approved by the board. The board should meet several times, preferably in person, to
review reports from management and outside advisors, learn the progress of the transaction and
provide guidance. Directors should receive reports and briefing information sufficiently before
meetings so that they can be studied and evaluated. Directors should be active in questioning
and analyzing the information and advice received from management and outside advisors. A
summary of the material provisions of the merger agreement should be prepared for the directors
and explained by counsel.378
(1)
In Van Gorkom,379 the Trans Union board approved the proposed merger at a
meeting without receiving notice of the purpose of the meeting, no investment banker was
invited to advise the board, and the proposed agreement was not available before the meeting and
was not reviewed by directors. This action contributed to the court’s conclusion that the board
was grossly negligent.
(2)
In Technicolor,380 notice of a special board meeting to discuss and approve an
acquisition proposal involving interested management was given to members of the board only
one day prior to the meeting, and it did not disclose the purpose of the meeting. Board members
were not informed of the potential sale of the corporation prior to the meeting, and it was
questioned whether the documents were available for the directors’ review at the meeting.
(3)
In contrast is Time,381 where the board met often to discuss the adequacy of
Paramount’s offer and the outside directors met frequently without management, officers or
directors.382
378
379
380
381
382
See, e.g., Moore Corp. Ltd. v. Wallace Computer Services, Inc., 907 F. Supp. 1545 (D. Del. 1995) for an in depth
description of a decision-making process that withstood review under enhanced scrutiny.
488 A.2d 858.
634 A.2d 345.
571 A.2d 1140.
See also Moran v. Household International, Inc., 500 A.2d 1346 (Del. 1985), where (i) before considering a rights plan
as a preventative mechanism to ward off future advance, the board received material on the potential takeover problem
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E.
The Decision to Remain Independent.
A board may determine to reject an unsolicited proposal. It is not required to exchange
the benefits of its long-term corporate strategy for short-term gain. However, like other
decisions in the takeover context, the decisions to “say no” must be adequately informed. The
information to be gathered and the process to be followed in reaching a decision to remain
independent will vary with the facts and circumstances, but in the final analysis the board should
seek to develop reasonable support for its decision.
A common ground for rejection is that the proposal is inadequate. Moreover, the
proposal may not reflect the value of recent or anticipated corporate strategy. Another ground is
that continued independence is thought to maximize shareholder value. Each of these reasons
seems founded on information about the value of the corporation and points to the gathering of
information concerning value.
A decision based on the inadequacy of the proposal or the desirability of continuing a
pre-existing business strategy is subject to the business judgment rule, in the absence of the
contemporaneous adoption of defensive measures or another response that proposes an
alternative means to realize shareholder value.383 Defensive measures are subject to enhanced
scrutiny, with its burden on the directors to demonstrate reasonableness. An alternative
transaction can raise an issue as to whether the action should be reviewed as essentially a
defensive measure. Moreover, the decision not to waive the operation of a poison pill or the
protection of a state business combination statute such as DGCL § 203 can be viewed as
defensive.384 A merger agreement that requires the merger to be submitted to shareholders, even
if the board has withdrawn its recommendation of the merger, as permitted by DGCL § 146, may
also be analyzed as defensive. In any case, and especially where it is likely that the suitor or a
shareholder will turn unfriendly, the authorized response should be based on a developed record
that demonstrates its reasonableness.
383
384
and the proposed plan, (ii) independent investment bankers and counsel attended the board meeting to advise the
directors, and (iii) ten of the board’s sixteen members were outside directors; and MSB Bancorp, 1998 WL 409355,
where during the period in question, the board met weekly, considered the offers, consulted with its legal and financial
advisors, and then made its conclusion as to which offer to pursue. For a summary of guidelines for counsel to develop
a suitable process for the board’s deliberations, see Frankle, Counseling the Board of Directors in Exploring
Alternatives, 1101 PLI/Corp. 261 (1998).
Whether the standards of review for a decision to remain independent are the same in the face of a cash bid that
potentially involves “Revlon duties” or a stock transaction that does not is unsettled. Compare, e.g., Wachtell, Lipton,
Rosen & Katz, Takeover Law and Practice, 1212 PLI/Corp. 801, 888, citing no authority: “If the proposal calls for a
transaction that does not involve a change in control within the meaning of QVC, it would appear that the traditional
business judgment rule would apply to the directors’ decision. If the acquisition proposal calls for a transaction that
would involve a change within the meaning of QVC, the enhanced-scrutiny Unocal test would apply.” Such a
conclusion would subject all director decisions to a reasonableness standard merely because of what transaction has
been proposed. In Time, 571 A.2d 1140, however, the Delaware Supreme Court suggested that a well-informed, fully
independent board ought to be accorded more deference than this where it has not initiated a sale, even though the
consideration for the sale presents advantages that are reasonable. On the other hand, in practice, it may be difficult to
avoid the defensive responses to a proposal, which would involve a reasonableness review, where the bidder is
persistent.
See e.g., Moore, 907 F. Supp. at 1556 (failure to redeem poison pill defensive).
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1.
Judicial Respect for Independence.
Delaware cases have acknowledged that directors may reject an offer that is inadequate
or reach an informed decision to remain independent. In a number of prominent cases, the
Delaware courts have endorsed the board’s decision to remain independent:
a.
In Time,385 the Delaware Supreme Court validated the actions of Time’s board in
the face of an all-shares cash offer from Paramount. The board had concluded that the
corporation’s purchase of Warner “offered a greater long-term value for the stockholders and,
unlike Paramount’s offer, did not pose a threat to Time’s survival and its ‘culture’.”386 In
approving these actions, the court determined that the board, which “was adequately informed of
the potential benefits of a transaction with Paramount,” did not have to abandon its plans for
corporate development in order to provide the shareholders with the option to realize an
immediate control premium.387 “Time’s board was under no obligation to negotiate with
Paramount.”388 According to the court, this conclusion was consistent with long-standing
Delaware law: “We have repeatedly stated that the refusal to entertain an offer may comport
with a valid exercise of a board’s business judgment.”389
b.
In Unitrin,390 the Delaware Supreme Court considered defensive actions taken by
Unitrin’s board in response to American General’s overtures. The board rejected the offer as
financially inadequate and presenting antitrust complications, but did not adopt defensive
measures to protect against a hostile bid until American General issued a press release
announcing the offer.391 Unitrin’s board viewed the resulting increase in Unitrin’s stock price as
a suggestion that speculative traders or arbitrageurs were buying up Unitrin stock and concluded
that the announcement constituted a “hostile act designed to coerce the sale of Unitrin at an
inadequate price.”392 In response, the board adopted a poison pill and an advance notice bylaw
provision for shareholder proposals.393 The directors then adopted a repurchase program for
Unitrin’s stock.394 The directors owned 23% of the stock and did not participate in the
repurchase program.395 This increased their percentage ownership and made approval of a
business combination with a shareholder without director participation more difficult.396 The
Delaware Court of Chancery ruled that the poison pill was a proportionate defensive response to
American General’s offer, but that the repurchase plan exceeded what was necessary to protect
shareholders from a low bid. The poison pill was not directly at issue when the Delaware
Supreme Court reviewed the case. The Supreme Court determined that the Court of Chancery
385
386
387
388
389
390
391
392
393
394
395
396
571 A.2d 1140.
Id. at 1149.
Id. at 1154.
Id.
Id. at 1152 (citing Macmillan, 559 A.2d at 1285 n.35; Van Gorkom, 448 A.2d at 881; and Pogostin v. Rice, 480 A.2d
619, 627 (Del. 1984).
651 A.2d 1361.
Id. at 1370.
Id.
Id.
Id. at 1370-71.
Id. at 1370.
Id. at 1371-72.
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used an incorrect legal standard and substituted its own business judgment for that of the
board.397 The Supreme Court remanded to the Court of Chancery to reconsider the repurchase
plan and determine whether it, along with the other defensive measures, was preclusive or
coercive and, if not, “within the range of reasonable defensive measures available to the
Board.”398
c.
In Revlon,399 the Delaware Supreme Court looked favorably on the board’s initial
rejection of Pantry Pride’s offer and its adoption of a rights plan in the face of a hostile takeover
at a price it deemed inadequate.400 The court did not suggest that Revlon’s board had a duty to
negotiate or shop the company before it “became apparent to all that the break-up of the
company was inevitable” and the board authorized negotiation of a deal, thus recognizing that
the company was for sale.401
d.
In Desert Partners,402 the court approved the USG board’s refusal to redeem a
poison pill to hinder an inadequate hostile offer and noted that the board had no duty to negotiate
where it had neither put the company up for sale nor entertained a bidding contest.403 “Once a
Board decides to maintain a company’s independence, Delaware law does not require a board of
directors to put their company on the auction block or assist a potential acquiror to formulate an
adequate takeover bid.”404
e.
In MSB Bancorp,405 the Delaware Chancery Court upheld the Board’s decision to
purchase branches of another bank in furtherance of its long-held business strategy rather than to
negotiate an unsolicited merger offer that would result in short-term gain to the shareholders.406
In reaching its conclusion, the Chancery Court applied the business judgment rule because it
determined that there was no defensive action taken by the Board in merely voting not to
negotiate the unsolicited merger offer which did not fit within its established long-term business
plan.407
2.
Defensive Measures.
When a Board makes a decision to reject an offer considered inadequate, the Board may
adopt defensive measures in case the suitor becomes unfriendly. Such a response will be
subjected to the proportionality test of Unocal, that the responsive action taken is reasonable in
relation to the threat posed.408 This test was further refined in Unitrin to make clear that
397
398
399
400
401
402
403
404
405
406
407
408
Id. at 1389.
Id. at 1390.
506 A.2d 173.
Id. at 180-81.
Id. at 182.
686 F. Supp. 1289 (applying Delaware law).
Id. at 1300.
Id. at 1300.
1998 WL 409355.
Id. at *4.
Id. at *3.
See, e.g., Quickturn, 721 A.2d at 1290.
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defensive techniques that are “coercive” or “preclusive” will not be considered to satisfy the
proportionality test:
An examination of the cases applying Unocal reveals a direct correlation between
findings of proportionality or disproportionality and the judicial determination of
whether a defensive response was draconian because it was either coercive or
preclusive in character. In Time, for example, [the Delaware Supreme Court]
concluded that the Time board’s defensive response was reasonable and
proportionate since it was not aimed at ‘cramming down’ on its shareholders a
management-sponsored alternative, i.e., was not coercive, and because it did not
preclude Paramount from making an offer for the combined Time-Warner
Company, i.e., was not preclusive.409
In Moran,410 the Delaware Supreme Court considered a shareholder rights plan adopted
by Household International not during a takeover contest, “but as a preventive mechanism to
ward off future advances.”411 The court upheld the pre-planned poison pill but noted that the
approval was not absolute.412 When the board “is faced with a tender offer and a request to
redeem the [rights plan], they will not be able to arbitrarily reject the offer. They will be held to
the same fiduciary standards any other board of directors would be held to in deciding to adopt a
defensive mechanism.”413
F.
The Pursuit of a Sale.
When a board decides to pursue a sale of the corporation (involving a sale of control
within the meaning of QVC), whether on its own initiative or in response to a friendly suitor, it
must “seek the best value reasonably available to the stockholders.”414 As the Delaware
Supreme Court stated in Technicolor: “[I]n the review of a transaction involving a sale of a
company, the directors have the burden of establishing that the price offered was the highest
value reasonably available under the circumstances.”415
1.
Value to Stockholders.
In Revlon, the Delaware Supreme Court imposed an affirmative duty on the Board to
seek the highest value reasonably available to the shareholders when a sale became inevitable.416
The duty established in Revlon has been considered by the Delaware courts on numerous
occasions, and was restated in QVC. According to the Delaware Supreme Court in QVC, the
409
410
411
412
413
414
415
416
Unitrin, 651 A.2d at 1387 (citations omitted).
500 A.2d 1346.
Id. at 1349.
Id. at 1354.
Id. See also Moore, 907 F. Supp. 1545; Desert Partners, 686 F. Supp. 1289; Unitrin, 651 A.2d 1361; Ivanhoe Partners
v. Newmont Mining Corp., 535 A.2d 1334 (Del. 1987); and Revlon, 506 A.2d 173, where the court considered
favorably a board’s defensive measures to protect its decision to remain independent.
QVC, 637 A.2d at 48; see also Matador, 729 A.2d at 290.
Technicolor, 634 A.2d at 361.
See Revlon, 506 A.2d 173; Elloway v. Pate, 238 S.W.3d 882 (Tex.App.—Houston [14th Dist.] 2007).
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duty to seek the highest value reasonably available is imposed on a board in the following
situations:
Under Delaware law there are, generally speaking and without excluding other
possibilities, two circumstances which may implicate Revlon duties. The first,
and clearer one, is when a corporation initiates an active bidding process seeking
to sell itself or to effect a business reorganization involving a clear break-up of the
company. However, Revlon duties may also be triggered where, in response to a
bidder’s offer, a target abandons its long-term strategy and seeks an alternative
transaction involving the break-up of the company.417
[W]hen a corporation undertakes a transaction which will cause: (a) a change in
corporate control; or (b) a break-up of the corporate entity, the directors’
obligation is to seek the best value reasonably available to the stockholders.418
The principles of Revlon are applicable to corporations which are not public
companies.419 Directors’ Revlon duties to secure the highest value reasonably attainable apply
not only in the context of break-up, but also in a change in control.420
2.
Ascertaining Value.
When the Revlon decision was first announced by the Delaware Supreme Court, many
practitioners read the decision to mandate an auction by a target company in order to satisfy the
board’s fiduciary duties (the so-called “Revlon duties”).421 After interpreting Revlon in Barkan,
Macmillan, Time, Technicolor, and QVC, however, the Delaware Supreme Court has clearly
indicated that an auction is not the only way to satisfy the board’s fiduciary duties. As the court
in Barkan stated:
Revlon does not demand that every change in the control of a Delaware
corporation be preceded by a heated bidding contest. Revlon is merely one of an
unbroken line of cases that seek to prevent the conflicts of interest that arise in the
field of mergers and acquisitions by demanding that directors act with scrupulous
concern for fairness to shareholders.422
One court has noted that when the board is negotiating with a single suitor and has no
reliable grounds upon which to judge the fairness of the offer, a canvas of the market is
necessary to determine if the board can elicit higher bids.423 However, the Delaware Supreme
417
418
419
420
421
422
423
QVC, 637 A.2d at 47 (citation omitted).
Id. at 48.
See Cirrus Holding v. Cirrus Ind., 794 A.2d 1191 (Del Ch. 2001).
Cirrus Holding v. Cirrus Ind., 794 A.2d 1191 (Del Ch. 2001); McMillan v. Intercago Corp., 768 A.2d 492, 502 (Del.
Ch. 2000); see also Krim v. ProNet, Inc., 744 A.2d 523 (Del. 1999) (Delaware law requires that once a change of
control of a company is inevitable the board must assume the role of an auctioneer in order to maximize shareholder
value).
See McBride, Revisiting Delaware Law and Mergers and Acquisitions: The Impact of QVC v. Paramount, 2 PLI
Course Handbook, 26th Ann. Inst. on Sec. Reg. 86 (1994).
Barkan, 567 A.2d at 1286.
In re Fort Howard Corp. Shareholders Litig., 1988 WL 83147 (Del. Ch. 1988).
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Court held in Barkan that when the directors “possess a body of reliable evidence with which to
evaluate the fairness of a transaction, they may approve that transaction without conducting an
active survey of the market.”424
The following cases indicate situations in which a board was not required to engage in an
active survey of the market. Most involve one-on-one friendly negotiations without other
bidders, although in some the target had earlier discussions with other potential bidders.
In Barkan,425 the corporation had been put “in play” by the actions of an earlier
bidder.
Instead of taking an earlier offer, the corporation instituted a management buyout (the
“MBO”) through an employee stock ownership program.427 In holding that the board did not
have to engage in a market survey to meet its burden of informed decision-making in good faith,
the court listed the following factors: (i) potential suitors had ten months to make some sort of
offer (due to early announcements), (ii) the MBO offered unique tax advantages to the
corporation that led the board to believe that no outside offer would be as advantageous to the
shareholders, (iii) the board had the benefit of the advice of investment bankers, and (iv) the
trouble the corporation had financing the MBO, indicating that the corporation would be
unattractive to potential suitors.428 In holding that an active market check was not necessary,
however, the court sounded a note of caution:
a.
426
The evidence that will support a finding of good faith in the absence of some sort
of market test is by nature circumstantial; therefore, its evaluation by a court must
be open-textured. However, the crucial element supporting a finding of good
faith is knowledge. It must be clear that the board had sufficient knowledge of
relevant markets to form the basis for its belief that it acted in the best interests of
the shareholders. The situations in which a completely passive approach to
acquiring such knowledge is appropriate are limited.429
b.
In In re Vitalink,430 Vitalink entered a merger agreement with Network Systems
431
Corporation.
While Vitalink had also conducted earlier discussions with two other companies,
the court found that Vitalink had not discussed valuation with those two companies, and thus did
not effectively canvas the market.432 In holding that the Vitalink board nevertheless met its
burden of showing that it acted in an informed manner in good faith, the court looked at the
following factors: (i) no bidder came forward in the 45 days that passed between the public
announcement of the merger and its closing; (ii) the parties negotiated for a number of months;
(iii) the board had the benefit of a fairness opinion from its investment banker; and (iv) the
424
425
426
427
428
429
430
431
432
Barkan, 567 A.2d at 1287.
567 A.2d 1279 (Del. 1989).
Id. at 1287.
Id. at 1282-83.
Id. at 1287-88.
Id. at 1288 (emphasis added).
1991 WL 238816.
Id. at *3-4.
Id. at *7.
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investment banker’s fee was structured to provide it an incentive to find a buyer who would pay
a higher price.433
As the Delaware Supreme Court noted in Van Gorkom, failure to take appropriate action
to be adequately informed as to a transaction violates the board’s duty of due care. Without a
firm blueprint to build adequate information, however, the passive market check entails a risk of
being judged as “doing nothing” to check the market or assess value.434
c.
In re MONY Group Inc. Shareholder Litigation435 involved stockholders seeking
a preliminary injunction against a stockholder vote on the merger of MONY with AXA. The
stockholders of MONY alleged that the defendant Board, having decided to put MONY up for
sale, did not fulfill its Revlon duty to seek the best transaction reasonably available to the
stockholders by forgoing a pre-agreement auction in favor of a process involving a single-bidder
negotiation followed by a post-agreement market check. The stockholders challenged (i) the
Board’s decision that the resulting negotiated merger proposal was the best proposal reasonably
available, (ii) the adequacy of the market check utilized and (iii) the adequacy of disclosures
made in a proxy statement sent to the stockholders seeking their approval of the merger. The
court granted a limited injunction relating solely to proxy statement disclosures concerning
payments under certain change-in-control agreements, but denied the request for a preliminary
injunction on the allegations as to the failure to get the best transaction.
The MONY Board had recognized that MONY had a number of problems and had
received a report from its investment banker listing a number of companies, including AXA, that
might acquire MONY. The Board considered and rejected the idea of publicly auctioning
MONY out of concern that a failed auction would expose MONY’s weaknesses and provide
competitors with information they could use to raid MONY’s insurance agents. Accordingly, the
Board instructed the CEO to quietly explore merger opportunities. After hearing the MONY
CEO’s report of his meeting with the AXA CEO and of prior discussions with other potential
partners, the MONY Board authorized solicitations of interest from AXA, but not from any other
potential bidder.
AXA initially proposed a price of $26 to $26.50 per MONY share, which led to
negotiations over several months that involved allowing AXA access to confidential information
under a confidentiality agreement. During these negotiations, the MONY CEO had advised
AXA the MONY change in control agreements would cost the survivor about $120 million.
After a period of negotiation, AXA proposed to acquire MONY for $28.50 per share, an
aggregate of about $1.368 billion, but later AXA determined that the change in control
agreements would actually cost about $163 million, not $120 million, and it lowered its offer to
$26.50 per share or $1.272 billion. At the end of these negotiations, the MONY Board rejected a
stock-for-stock merger with AXA that purported to reflect the $26.50 per share price by a fixed
share exchange ratio that was collared between $17 and $37 per MONY share. The Board also
concluded that the change in control agreements were too rich and that AXA’s offer price would
have been higher if it had not been for the change in control agreements.
433
434
435
Id. at *11-12.
See Barkan, 567 A.2d at 1287 (there is no single method that a board must employ to become informed).
In re MONY Group Inc. S’holder Litig., 852 A.2d 9 (Del. Ch. 2004).
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Shortly after the AXA offer was rejected, the MONY Board engaged a compensation
consultant to analyze the change in control agreements and received a report that change in
control agreements costs typically range from 1% to 3% of a proposed transaction price (and
sometimes up to 5%), but that MONY’s change in control agreements represented 15% of the
previously proposed AXA merger price. Ultimately, the Board informed senior management
that it would not renew the change in control agreements when they expired, and offered
management new change in control agreements that lowered the payout provisions to between
5% and 7% of the AXA transaction’s value, which the management parties accepted.
Two months later, the AXA CEO contracted the MONY CEO to ask if MONY would be
interested in an all-cash transaction, but the Board would not permit the MONY CEO to engage
in sale negotiations until the change in control agreements had been amended, thus postponing
the talks. When the AXA CEO then made an offer of $29.50 cash per MONY share, the MONY
CEO informed him that the change in control agreements had been modified and that the offer
should be $1.50 higher to reflect the change. At the end of this round of negotiations, a merger
agreement was signed providing for the payment of $31 cash for each MONY share and a
negotiated provision allowing MONY to pay a dividend of $0.25 per share before the merger
was consummated. The merger consideration reflected a 7.3% premium to MONY’s thencurrent trading price, as well as valuing MONY’s equity at $1.5 billion and the total transaction
(including liabilities assumed) at $2.1 billion.
MONY accepted a broad “window shop” provision and a fiduciary-out termination
clause which required MONY to pay AXA a termination fee equal to 3.3% of the equity value
and 2.4% of the transaction value. In the several months following the announcement of the
merger agreement no one made a competing proposal, although there was one expression of
interest if the AXA deal failed.
The plaintiff stockholders claimed that the MONY board breached its fiduciary duties
under Revlon by failing to procure the best possible price for MONY, presumably through a
public auction. Citing Revlon and QVC, the court found that the consequences of a sale of
control imposed special obligations on the directors, particularly the obligation of acting
reasonably to seek the transaction offering the best value reasonably available for stockholders
(i.e., getting the best short-term price for stockholders), but that these requirements did not
demand that every change of control be preceded by a heated bidding contest, noting that a board
could fulfill its duty to obtain the best transaction reasonably available by entering into a merger
agreement with a single bidder, establishing a “floor” for the transaction, and then testing the
transaction with a post-agreement market check. The court wrote that the traditional inquiry was
whether the board was adequately informed and acted in good faith. Furthermore, in the sale of
control context this inquiry was heightened such that the directors had the burden of proving that
they were adequately informed and acted reasonably, with the court scrutinizing the adequacy of
the decision-making process, including the information on which the directors based their
decision and the reasonableness of the directors’ action in light of the circumstances then
existing. The question was whether the directors made a reasonable decision, not a perfect
decision. If a Board selected one of several reasonable alternatives, the court should not secondguess that choice even though it might have decided otherwise or subsequent events might have
cast doubt on the board’s determination.
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The plaintiffs argued that the Board relied too much upon the MONY CEO to determine
and explore alternatives, and in doing so that it had breached its fiduciary duties, since the CEO
and other members of MONY senior management stood to gain excessive payments under the
change in control agreements if MONY was sold. With respect to the plaintiff stockholders
argument that the Board should have established a special committee to continue negotiations
with AXA, the court held that a board could rely on the CEO to conduct negotiations and that the
involvement of an investment bank in the negotiations was not required, particularly since the
Board actively supervised the CEO’s negotiations and the CEO had acted diligently in securing
improvements for MONY. The court further noted that the Board had repeatedly demonstrated
its independence and control, first in rejecting the stock for stock transaction and second in
reducing the insiders’ change in control agreements benefits.
In addressing the contention that there should have been a public auction, the court
concluded that a single-bidder approach offered the benefits of protecting against the risk that an
auction would fail and avoiding a premature disclosure to the detriment of MONY’s thenongoing business, and noted that the Board had taken into consideration a number of company
and industry specific factors in deciding not to pursue a public auction or active solicitation
process and not to make out-going calls to potentially interested parties after receiving AXA’s
cash proposal. The court noted that the Board members were financially sophisticated,
knowledgeable about the insurance and financial services industry, and knew the industry and
the potential strategic partners available to MONY. The Board had been regularly briefed on
MONY’s strategic alternatives and industry developments over recent years. The Board was
also advised as to alternatives to the merger. The court wrote that this “financially sophisticated
Board engaged CSFB for advice in maximizing stockholder value [and] … obtained a fairness
opinion from CSFB, itself incentivized to obtain the best available price due to a fee that was set
at 1% of transaction value….,” noting that CSFB was not aware of any other entity that had an
interest in acquiring MONY at a higher price. One witness testified that CSFB did not
participate directly in the negotiations due to a reasonable concern that CSFB’s involvement
could cause AXA to get its own investment banker, which MONY believed would increase the
risk of leaks and might result in a more extensive due diligence process to its detriment. The
court found that using these resources and the considerable body of information available to it,
the Board had determined that, because MONY and AXA shared a similar business model, AXA
was a strategic fit for MONY and thus presented an offer that was the best price reasonably
available to stockholders.
Under the market check provisions which the court found reasonable and adequate,
MONY could not actively solicit offers after announcement of the transaction and before the
stockholder vote, but could, subject to a reasonable termination fee, pursue inquiries that could
be reasonably expected to lead to a business combination more favorable to stockholders. The
court found the five-month period while the transaction pended after it was announced (for SEC
filing clearance and vote solicitation) was an adequate time for a competing bidder to emerge
and complete its due diligence.
The court concluded that the termination fee (3.3% of MONY’s total equity value and
2.4% of the total transaction value) was within the range of reasonableness. Moreover, the court
said that the change in control agreements were “bidder neutral” in that they would affect any
potential bidder in the same fashion as they affected AXA. Thus, the court found the five-month
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market check more than adequate to determine if the price offered by AXA was the best price
reasonably available, which supported a conclusion that the board acted reasonably and had
satisfied its Revlon duties.
The plaintiffs alleged that the proxy statement was misleading because it failed to
disclose the percentage of transaction value of aggregate payments to be made under the
amended change in control agreements as compared to payments in similar transactions. The
MONY Board’s expert showed that the mean change-in-control payment (as a percentage of
deals for selected financial services industry transactions) was 3.37%, with the 25th and 75th
percentile for such transactions being .94% and 4.92%, respectively. The base case under the
original change in control agreements for MONY would have been over 15% of the original
offer and the amended change in control agreements lowered that to 6%, which was still well
above the 75th percentile. The court noted the history of AXA’s bidding as showing that there
was essentially a 1:1 ratio between the value of the change in control agreements and the amount
per share offered. Because the change in control agreements’ value was above the amount paid
in change in control agreements in more than 75% of comparable transactions, the court was
persuaded that the proxy statement needed to include disclosure of information available to the
board about the size of the change in control agreements payments as compared to comparable
transactions, noting that the materiality of such disclosure was heightened by the Board’s
rejection of the original offer, at least in part because of the original outsized change in control
agreements’ payment obligations. The court concluded the shareholders were entitled to know
that the change in control agreements remained unusually large when deciding whether to vote to
approve the $31 per share merger price or vote “no” or demand appraisal under statutory merger
appraisal procedures. Moreover, the court said that more disclosure about comparative
information was made necessary to the extensive disclosure that was in the proxy statement
about steps the Board had taken to lower the payments under the change in control agreements
since that disclosure had created the strong impression that the amended change in control
agreements were in line with those in comparable transactions. The court said that the proxy
statement had misleadingly implied that the payments under the change in control agreements
were consistent with current market practice when they were in fact considerably more lucrative
than was normal. The court ordered the additional disclosure about the change in control
agreements.
After the initial decision in the MONY Group case, the board of MONY reset and pushed
back the record date for the vote on the merger by several months. The same court held in
another decision that the directors did not breach their duties to existing stockholders in so doing
even though the extended record date included additional stockholders (arbitrageurs) who had
recently purchased shares and who were likely to vote in favor of the merger.436
3.
Process Changes.
In re Toys “R” Us, Inc. Shareholder Litigation437 involved a motion to enjoin a vote of
the stockholders of Toys “R” Us, Inc. to consider approving a merger with an acquisition vehicle
formed by a group led by Kohlberg Kravis Roberts & Co. (“KKR”) that resulted from a lengthy,
436
437
In re MONY Group Inc. Shareholders Litigation, 853 A.2d 661 (Del. Ch. 2004).
877 A.2d 975 (Del. Ch. 2005).
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publicly-announced search for strategic alternatives and presented merger consideration
constituting a 123% premium over the per share price when the strategic process began 18
months previously. During the strategic process, the Toys “R” Us board of directors, nine of
whose ten members were independent, had frequent meetings to explore the company’s strategic
options with an open mind and with the advice of expert advisors.
Eventually, the Board settled on the sale of the company’s most valuable asset, its toy
retailing business, and the retention of the company’s baby products retailing business, as its
preferred option after considering a wide array of options, including a sale of the whole
company. The company sought bids from a large number of the most logical buyers for the toy
business, and it eventually elicited attractive expressions of interest from four competing bidders
who emerged from the market canvass. When due diligence was completed, the Board put the
bidders through two rounds of supposedly “final bids” for the toys business. In this process, one
of the bidders expressed a serious interest in buying the whole company. The Board was
presented with a bid that was attractive compared with its chosen strategy in light of the
valuation evidence that its financial advisors had presented, and in light of the failure of any
strategic or financial buyer to make any serious expression of interest in buying the whole
company despite the Board’s openly expressed examination of its strategic alternatives.
Recognizing that the attractive bids it had received for the toys business could be lost if it
extended the process much longer, the Executive Committee of the Board, acting in conformity
with direction given to it by the whole Board, approved the solicitation of bids for the entire
company from the final bidders for the toys business, after a short period of due diligence.
When those whole company bids came in, the winning bid of $26.75 per share from KKR
topped the next most favorable bid by $1.50 per share. After a thorough examination of its
alternatives and a final reexamination of the value of the company, the Board decided that the
best way to maximize stockholder value was to accept the $26.75 bid.
In its proposed merger agreement containing the $26.75 offer, KKR asked for a
termination fee of 4% of the implied equity value of the transaction to be paid if the company
terminated to accept another deal, as opposed to the 3% offered by the company in its proposed
draft of merger agreement. Knowing that the only other bid for the company was $1.50 per
share or $350 million less, the company’s negotiators nonetheless bargained the termination fee
down to 3.75% the next day, and bargained down the amount of expenses KKR sought in the
event of a naked no vote.
The plaintiffs faulted the Board for failing to fulfill its duty to act reasonably in pursuit of
the highest attainable value for the company’s stockholders, complaining that the Board’s
decision to conduct a brief auction for the full company from the final bidders for the toy
business was unreasonable and that the Board should have taken the time to conduct a new, fullblown search for buyers and that the Board unreasonably locked up the deal by agreeing to
draconian deal termination measures that precluded any topping bid. The Chancery Court
rejected those arguments, finding that the Board made reasonable choices in confronting the real
world circumstances it faced, was supple in reacting to new circumstances and was adroit in
responding to a new development that promised greater value to the stockholders.
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Likewise, the Chancery Court found the choice of the Board’s negotiators not to press too
strongly for a reduction of KKR’s desired 4% termination fee all the way to 3% initially
proposed by the company was reasonable, given that KKR had topped the next best bid by such a
big margin and the Board’s negotiators did negotiate to reduce the termination fee from 4% to
3.75%. Furthermore, the size of the termination fee and the presence in the merger agreement of
a provision entitling KKR to match any competing bid received did not act as a serious barrier to
any bidder willing to pay materially more than KKR’s price.
In rejecting the plaintiffs’ Revlon arguments and finding the Board’s decision to negotiate
with four bidders who had previously submitted bids to buy part of the company, rather than
conduct a wide auction, was reasonable and Revlon-compliant, the Chancery Court wrote:
The plaintiffs, of course, argue that the Toys “R” Us board made a hurried
decision to sell the whole Company, after feckless deliberations, rushing headlong
into the arms of the KKR Group when a universe of worthier, but shy, suitors
were waiting to be asked to dance. The M & A market, as they view it, is
comprised of buyers of exceedingly modest and retiring personality, too genteel to
make even the politest of uninvited overtures: a cotillion of the reticent.
For that reason, the Company’s nearly year long, publicly announced
search for strategic alternatives was of no use in testing the market. Because that
announced process did not specifically invite offers for the entire Company from
buyers, the demure M & A community of potential Cyranos, albeit ones afraid to
even speak through front men, could not be expected to risk the emotional blow
of rejection by Toys “R” Us. Given its failure to appreciate the psychological
barriers that impeded possible buyers from overcoming the emotional paralysis
that afflicts them in the absence of a warm, outreached hand, the Company’s
board wrongly seized upon the KKR Group’s bid, without reasonable basis (other
than, of course, its $350 million superiority to the Cerberus bid and its
attractiveness when compared to the multiple valuations that the board reviewed).
The plaintiffs supplement this dubious big-picture with a swarm of nits
about several of the myriad of choices directors and their advisors must make in
conducting a thorough strategic review. Rather than applaud the board’s supple
willingness to change direction when that was in the stockholders’ best interest,
the plaintiffs instead trumpet their arguable view that the directors and their
advisors did not set out on the correct course in the first instance. Even the
reasonable refusal of the Company to confirm or deny rumors in the Wall Street
Journal is flown in to somehow demonstrate the board’s failure to market the
Company adequately.
It is not hyperbole to say that one could spend hundreds of pages swatting
these nits out of the air. In the fewer, but still too numerous, pages that follow, I
will attempt to explain in a reader-friendly fashion why the board’s process for
maximizing value cannot reasonably be characterized as unreasonable.
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I begin by noting my disagreement with the plaintiffs about the nature of
players in the American M & A markets. They are not like some of us were in
high school. They have no problem with rejection. The great takeover cases of
the last quarter century — like Unocal, QVC, and — oh, yeah — Revlon — all
involved bidders who were prepared, for financial advantage, to make hostile,
unsolicited bids. Over the years, that willingness has not gone away.
Given that bidders are willing to make unsolicited offers for companies
with an announced strategy of remaining independent, boards like Toys “R” Us
know that one way to signal to buyers that they are open to considering a wide
array of alternatives is to announce the board’s intention to look thoroughly at
strategic alternatives. By doing that, a company can create an atmosphere
conducive to offers of a non-public and public kind, while not putting itself in a
posture that signals financial distress.
In that regard, the defendants plausibly argue that if the Company’s board
had put a “for sale” sign on Toys “R” Us when its stock price was at $12.00 per
share, the ultimate price per share it would have received would likely have begun
with a “1” rather than a “2” and not have been anywhere close to $26.75 per
share. The board avoided that risk by creating an environment in which it
simultaneously recognized the need to unlock value and signaled its openness to a
variety of means to accomplish that desirous goal, while at the same time
notifying buyers that no emergency required a sale.
By this method, I have no doubt that Toys “R” Us caught the attention of
every retail industry player that might have had an interest in a strategic deal with
it. That is, in fact, what triggered calls from PETsMART, Home Depot, Office
Depot, Staples, and Best Buy, all of whom potentially wanted to buy some of the
Company’s real estate.
In a marketplace where strategic buyers have not felt shy about “jumping”
friendly deals crafted between their industry rivals, the board’s open search for
strategic alternatives presented an obvious opportunity for retailers, of any size or
stripe, who thought a combination with all or part of the Company made sense for
them, to come forward with a proposal. That they did not do so, early or late in
the process, is most likely attributable to their inability to formulate a coherent
strategy that would combine the Company’s toy and baby store chains into
another retail operation. The plaintiffs’ failure to identify, or cite to any industry
analyst touting the existence of, likely synergistic combinations is telling.
The approach that the board took not only signaled openness to possible
buyers, it enabled the board to develop a rich body of knowledge regarding the
value not only of the Company’s operations, but of its real estate assets. That
body of knowledge provided the board with a firm foundation to analyze potential
strategic options and constituted useful information to convince buyers to pay top
dollar.
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The Chancery Court further found no fault in the Board’s willingness to allow two of the
bidders to present a joint bid:
Likewise, the decision to accede to KKR and Vornado/Bain’s request to
present a joint bid cannot be deemed unreasonable. The Cerberus consortium had
done that earlier, as to the Global Toys business only. Had First Boston told KKR
and Vornado/Bain “no,” they might not have presented any whole Company bid
at all. Their rationale for joining together, to spread the risk that would be
incurred by undertaking what the plaintiffs have said is the largest retail
acquisition by financial buyers ever, was logical and is consistent with an
emerging practice among financial buyers. By banding together, these buyers are
able to make bids that would be imprudent, if pursued in isolation. The plaintiffs’
continued description of the KKR Group’s bid as “collusive,” is not only
linguistically imprecise, it is a naked attempt to use inflammatory words to mask a
weak argument. The “cooperative” bid that First Boston permitted the KKR
Group to make gave the Company a powerful bidding competitor to the Cerberus
consortium, which included, among others, Goldman Sachs.
In rejecting plaintiffs’ other major argument that the Board acted unreasonably because
the merger agreement with KKR included deal protection measures that, in the plaintiffs’ view,
precluded other bidders from making a topping offer, the Chancery Court wrote:
It is no innovation for me to state that this court looks closely at the deal
protection measures in merger agreements. In doing so, we undertake a nuanced,
fact-intensive inquiry [that] does not presume that all business circumstances are
identical or that there is any naturally occurring rate of deal protection, the deficit
or excess of which will be less than economically optimal. Instead, that inquiry
examines whether the board granting the deal protections had a reasonable basis
to accede to the other side’s demand for them in negotiations. In that inquiry, the
court must attempt, as far as possible, to view the question from the perspective of
the directors themselves, taking into account the real world risks and prospects
confronting them when they agreed to the deal protections. As QVC clearly
states, what matters is whether the board acted reasonably based on the
circumstances then facing it.
***
As the plaintiffs must admit, neither a termination fee nor a matching right
is per se invalid. Each is a common contractual feature that, when assented to by
a board fulfilling its fundamental duties of loyalty and care for the proper purpose
of securing a high value bid for the stockholders, has legal legitimacy.
***
Contributing to this negotiating dynamic, no doubt, were prior judicial
precedents, which suggested that it would not be unreasonable for the board to
grant a substantial termination fee and matching rights to the KKR Group if that
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was necessary to successfully wring out a high-value bid. Given the Company’s
lengthy search for alternatives, the obvious opportunity that unsolicited bidders
had been afforded to come forward over the past year, and the large gap between
the Cerberus and the KKR Group bids, the board could legitimately give more
weight to getting the highest value bid out of the KKR Group, and less weight to
the fear that an unlikely higher-value bid would emerge later. After all, anyone
interested had had multiple chances to present, however politely, a serious
expression of interest — none had done so.
Nor was the level of deal protection sought by the KKR Group
unprecedented in magnitude. In this regard, the plaintiffs ignore that many deals
that were jumped in the late 1990s involved not only termination fees and
matching rights but also stock option grants that destroyed pooling treatment, an
additional effect that enhanced the effectiveness of the barrier to prevent a lateremerging bidder.
***
In view of this jurisprudential reality, the board was not in a position to
tell the KKR Group that they could not have any deal protection. The plaintiffs
admit this and therefore second-guess the board’s decision not to insist on a
smaller termination fee, more like 2.5% or 3%, and the abandonment of the
matching right. But that, in my view, is precisely the sort of quibble that does not
suffice to prove a Revlon claim.
***
It would be hubris in these circumstances for the court to conclude that the
board acted unreasonably by assenting to a compromise 3.75% termination fee in
order to guarantee $26.75 per share to its stockholders, and to avoid the
substantial risk that the KKR Group might somehow glean the comparatively
large margin by which it had outbid Cerberus.
***
The central purpose of Revlon is to ensure the fidelity of fiduciaries. It is
not a license for the judiciary to set arbitrary limits on the contract terms that
fiduciaries acting loyally and carefully can shape in the pursuit of their
stockholders’ interest.
***
This is not to say that this court is, or has been, willing to turn a blind eye
to the adoption of excessive termination fees, such as the 6.3% termination fee in
Phelps Dodge that Chancellor Chandler condemned, that present a more than
reasonably explicable barrier to a second bidder, or even that fees lower than 3%
are always reasonable. But it is to say that Revlon‘s purpose is not to set the
judiciary loose to enjoin contractual provisions that, upon a hard look, were
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reasonable in view of the benefits the board obtained in the other portions of an
integrated contract.
In finding that the board’s process passed muster and after noting the scrupulous way in
which management refused to even discuss future employment prospects with any bidder (or
even meet with a bidder in the absence of its financial adviser), the Chancery Court noted that
the financial adviser had introduced an unnecessary issue by agreeing (after the merger
agreement was signed and with the permission of the board) to provide buy-side financing for
KKR:
First Boston did create for itself, and therefore its clients, an unnecessary
issue. In autumn 2004, First Boston raised the possibility of providing buy-side
financing to bidders for Global Toys. First Boston had done deals in the past with
many of the late-round financial buyers, most notably with KKR. The board
promptly nixed that idea. At the board’s insistence, First Boston had, therefore,
refused to discuss financing with the KKR Group, or any bidder, before the
merger was finalized. But, when the dust settled, and the merger agreement was
signed, the board yielded to a letter request by First Boston to provide financing
on the buy-side for the KKR Group.
That decision was unfortunate, in that it tends to raise eyebrows by
creating the appearance of impropriety, playing into already heightened
suspicions about the ethics of investment banking firms. Far better, from the
standpoint of instilling confidence, if First Boston had never asked for permission,
and had taken the position that its credibility as a sell-side advisor was too
important in this case, and in general, for it to simultaneously play on the buy-side
in a deal when it was the seller’s financial advisor. In that respect, it might have
been better, in view of First Boston’s refusal to refrain, for the board of the
Company to have declined the request, even though the request came on May 12,
2005, almost two months after the board had signed the merger agreement.
My job, however, is not to police the appearances of conflict that, upon
close scrutiny, do not have a causal influence on a board’s process. Here, there is
simply no basis to conclude that First Boston’s questionable desire to provide
buy-side financing ever influenced it to advise the board to sell the whole
Company rather than pursue a sale of Global Toys, or to discourage bidders other
than KKR, or to assent to overly onerous deal protection measures during the
merger agreement negotiations.
4.
Disparate Treatment of Stockholders